Inflation Risk and the Finance-Growth Nexus

56 Pages Posted: 11 Mar 2021

See all articles by Alexandre Corhay

Alexandre Corhay

University of Toronto - Rotman School of Management

Jincheng Tong

University of Toronto

Date Written: February 1, 2021

Abstract

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

Corhay, Alexandre and Tong, Jincheng, Inflation Risk and the Finance-Growth Nexus (February 1, 2021). Rotman School of Management Working Paper No. 3795679, Available at SSRN: https://ssrn.com/abstract=3795679 or http://dx.doi.org/10.2139/ssrn.3795679

Alexandre Corhay (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
4169780512 (Phone)

Jincheng Tong

University of Toronto ( email )

Toronto, Ontario M5S1L1
Canada

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