Inflation, Financial Markets, and Capital Formation

This explanation has been articulated in a number of recent papers. See, for example, Azariadis and Smith (forthcoming), Boyd and Smith (forthcoming), and Schreft and Smith (forthcoming and 1994). A consensus among economists seems to be that high rates of inflation cause " problems, " not just for some individuals, but for aggregate economic performance. There is much less agreement about what these problems are and how they arise. We propose to explain how inflation adversely affects an economy by arguing that high inflation rates tend to exacerbate a number of financial market frictions. In doing so, inflation interferes with the provision of investment capital, as well as its allocation. 1 Such interference is then detrimental to long-run capital formation and to real activity. Moreover, high enough rates of inflation are typically accompanied by highly variable inflation and by variability in rates of return to saving on all kinds of financial instruments. We argue that, by exacerbating various financial market frictions, high enough rates of inflation force investors' returns to display this kind of variability. It seems difficult then to prevent the resulting variability in returns from being transmitted into real activity. Unfortunately, for our understanding of these phenomena, the effects of permanent increases in the inflation rate for long-run activity seem to be quite complicated and to depend strongly on the initial level of the inflation rate. For example, Bullard and Keating (forthcoming) find that a permanent, policy-induced increase in the rate of inflation raises the long-run level of real activity for economies whose initial rate of inflation is relatively low. For economies experiencing moderate initial rates of inflation, the same kind of change in inflation seems to have no significant effect on long-run real activity. However, for economies whose initial inflation rates are fairly high, further increases in inflation significantly reduce the long-run level of output. Any successful theory of how inflation affects real activity must account for these nonmonotonicities. Along the same lines, Bruno and Easterly (1995) demonstrate that a number of economies have experienced sustained inflations of 20 percent to 30 percent without suffering any apparently major adverse consequences. However, once the rate of inflation exceeds some critical level (which Bruno and Easterly estimate to be about 40 percent), significant declines occur in the level of real activity. This seems consistent with the results of Bullard and Keating. Evidence is also accumulating that inflation adversely affects …