Mitigating the Growth-Effects of Inflation through Financial Development

This paper examines the growth-effects of inflation at alternative stages of financial development. We propose an endogenous growth model where intermediated savings generate capital. Informational problems cause banks to ration credit and hold liquid assets offering (real) returns that vary inversely with inflation. Inflation therefore acts like a tax on capital accumulation. However financial development lessens credit-rationing, which reduces the demand for these liquid assets and softens the incidence of the inflation tax. Sizeable and statistically significant interactions between inflation and measures of financial development in cross-country and panel regressions provide empirical support for our model.