Academic journal article Federal Reserve Bank of St. Louis Review

Inflation, Financial Markets, and Capital Formation

Academic journal article Federal Reserve Bank of St. Louis Review

Inflation, Financial Markets, and Capital Formation

Article excerpt

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 the allocative function of capital markets, depressing the level of activity in those markets and reducing investors' rates of return. Again, however, these effects seem highly nonlinear. In a cross-sectional analysis, for example, Boyd, Levine, and Smith (1995) divide countries into quartiles according to their average rates of inflation. The lowest inflation quartile has the highest level of financial market activity, and the highest inflation quartile has the lowest level of financial market activity However, the two middle quartiles display only very minor differences. Thus for the financial system, as for real activity, there seem to be threshold effects associated with the inflation rate.

Moreover, as we will show, high rates of inflation tend to depress the real returns equity-holders receive and to increase their variability. In Korea and Taiwan, there were fairly pronounced jumps in the rate of inflation in 1988 and 1989, respectively. In each country, before those dates, inflation's effects on rates of return to equity, rate of return volatility, and transactions volume appear to be insignificant. After the dates in question, these effects are generally highly significant. Thus it seems possible that -- to adversely affect the financial system -- inflation must be "high enough."

Why does inflation affect financial markets and real activity this way? We produce a theoretical model in which -- consistent with the evidence -- higher inflation reduces the rate of return received by savers in all financial markets. …

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