Inflation Risk and the Finance-Growth Nexus
56 Pages Posted: 11 Mar 2021
Date Written: February 1, 2021
This paper shows that the effect of inflation on asset prices and real aggregates depends on the financial intermediation sector. When firms finance using nominal long-term debt issued by financial intermediaries, unexpected changes in inflation lead to a wealth transfer across sectors. Higher inflation decreases firms' real liabilities and default risk, which helps reduce debt overhang. However, it hurts intermediaries' balance sheet, leading to a contraction in credit. We show theoretically that the ultimate effect of inflation depends on the tightness of financing constraints in the intermediation sector. We find strong empirical evidence consistent with these results. We also show that an inflation policy responding to both financial and real variables can help stabilize our economy.
Keywords: Inflation, Asset Prices, Credit Risk, Debt Deflation, Financial Intermediation, Monetary Policy, General Equilibrium Model, Recursive Preferences
JEL Classification: E12, E31, E44, E52, G01, G32, G35
Suggested Citation: Suggested Citation