A critical appraisal of McKinnon’s complementary hypothesis: Does the real rate of return on money matter for investment in developing countries?

Abstract

McKinnon’s (1973) complementary hypothesis predicts that money and investment are complementary due to a self-financed investment, and that a real deposit rate is the key determinant of capital formation for financially constrained developing economies. This paper critically appraises this contention by conducting a vigorous empirical approach by using panel data for 108 developing countries over the sample period of 1970-2006. The long-run and dynamic estimation results based on McKinnon’s theoretical model are supportive of the hypothesis. However, when the investment model is conditioned by such factors as financial development, different income levels across developing countries, external inflows, public finance and trade constraints, the credibility of the hypothesis has been undermined.