Federico Guerrero Modeling the Adverse Effects of High Inflation Uncertainty on Capital Accumulation

Increases in uncertainty have ambiguous effects on the rate of investment in complete contracts models. Consequently, in order to model the adverse effects of high inflation on capital accumulation, macro models overimpose a CIA constraint to buy capital goods. The fall in investment is thus due to an increase in the effective price of capital goods, and not due to inflation uncertainty. In incomplete contracts models, the effects of uncertainty on investment decisions are unambiguously negative, in the absence of long-term contracts (LTCs). Since one of the main effects of high inflation is to provide the incentives for those contracts to vanish, this paper models this feature, endogeneizing LTCs disappearance in an incomplete contracts setup, and by so doing permits to explain a fall in investment that is entirely due to inflation uncertainty. JEL Classification: E31, E22, O12, O42, D92. This paper investigates why and through which mechanisms could inflation have adverse effects on capital accumulation, as the economy moves to a state of 'maximum inflationary uncertainty', when crucial aspects of that uncertainty are non-contractible. Typical accounts of high inflation episodes remark these last two features of the inflationary process with emphasis. When we are asked why high inflation could harm capital accumulation, we like to respond things in the following spirit (Lloyd Thomas's Money, Banking, and Financial Markets, pp. 442-443, 1996): "Because inflation creates uncertainty and impairs investment spending, it is essential that [the central bank] remain vigilant against inflation, if satisfactory long-run growth is to be achieved" But in our prototypical macroeconomic model, the Ramsey model of growth, we impose a CIA constraint on firms for their purchase of capital goods, so that (anticipated) 1 I have benefited from comments from Roger Betancourt, Fernando Broner, and Rachel Kranton on a previous version of this paper, and have received useful suggestions from seminar participants in the International and the Development student seminars at the University of Maryland at College Park. Errors, inconsistencies and omissions are my sole responsibility. 2 See Bresciani Turroni (1937) for a review of the case of the German high inflation preceding the hyperinflation of 1923, and Heymann and Leijonhufvud (1995) for more recent experiences in Latin America during the 1980s.