M AY / J U N E 1 9 9 6 Sangmok Choi is an economist at the Korean Ministry of Finance. Bruce D. Smith is a professor of economics at the University of Texas, Austin. John H. Boyd is a professor of finance at the University of Minnesota and is with the Federal Reserve Bank of Minneapolis. The authors thank Satyajit Chatterjee; Pamela Labadie; and the participants of seminars at the University of Texas, the Federal Reserve Bank of Dallas, and the World Bank for helpful comments on an earlier draft of this article. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. in the rate of inflation raises the long-run Inflation, level of real activity for economies whose initial rate of inflation is relatively low. For Financial economies experiencing moderate initial rates of inflation, the same kind of change Markets, in inflation seems to have no significant effect on long-run real activity. However, and Capital for economies whose initial inflation rates are fairly high, further increases in infla- Formation tion significantly reduce the long-run level of output. Any successful theory of how Sangmok Choi, Bruce D. inflation affects real activity must account Smith, and John H. Boyd for these nonmonotonicities. Along the same lines, Bruno and consensus among economists seems Easterly (1995) demonstrate that a num- to be that high rates of inflation ber of economies have experienced sus- A cause “problems,” not just for some tained inflations of 20 percent to 30 per- individuals, but for aggregate economic cent without suffering any apparently performance. There is much less agree- major adverse consequences. However, ment about what these problems are and once the rate of inflation exceeds some how they arise. We propose to explain critical level (which Bruno and Easterly how inflation adversely affects an economy estimate to be about 40 percent), signifi- by arguing that high inflation rates tend to cant declines occur in the level of real ac- exacerbate a number of financial market tivity. This seems consistent with the re- frictions. In doing so, inflation interferes sults of Bullard and Keating. with the provision of investment capital, Evidence is also accumulating that in- as well as its allocation.1 Such interference flation adversely affects the allocative func- is then detrimental to long-run capital for- tion of capital markets, depressing the level mation and to real activity. Moreover, high of activity in those markets and reducing enough rates of inflation are typically ac- investors’ rates of return. Again, however, companied by highly variable inflation and these effects seem highly nonlinear. In a by variability in rates of return to saving cross-sectional analysis, for example, Boyd, on all kinds of financial instruments. We Levine, and Smith (1995) divide countries argue that, by exacerbating various finan- into quartiles according to their average cial market frictions, high enough rates of rates of inflation. The lowest inflation inflation force investors’ returns to display quartile has the highest level of financial this kind of variability. It seems difficult market activity, and the highest inflation then to prevent the resulting variability in quartile has the lowest level of financial returns from being transmitted into real market activity. However, the two middle activity. quartiles display only very minor differ- Unfortunately, for our understanding ences. Thus for the financial system, as for 1 of these phenomena, the effects of perma- real activity, there seem to be threshold ef- This explanation has been artic- ulated in a number of recent nent increases in the inflation rate for fects associated with the inflation rate. papers. See, for example, long-run activity seem to be quite compli- Moreover, as we will show, high rates Azariadis and Smith (forthcom- cated and to depend strongly on the initial of inflation tend to depress the real returns ing), Boyd and Smith (forth- level of the inflation rate. For example, equity-holders receive and to increase coming), and Schreft and Bullard and Keating (forthcoming) find their variability. In Korea and Taiwan, Smith (forthcoming and that a permanent, policy-induced increase there were fairly pronounced jumps in the 1994). F E D E R A L R E S E RV E B A N K O F ST. L O U I S MAY / J U N E 1 9 9 6 rate of inflation in 1988 and 1989, respec- lower rates of interest and therefore must tively. In each country, before those dates, do something to keep them from seeking inflation’s effects on rates of return to eq- external finance. The specific response uity, rate of return volatility, and transac- here is that markets ration credit, and tions volume appear to be insignificant. more severe rationing accompanies higher After the dates in question, these effects inflation. This rationing then limits the are generally highly significant. Thus it availability of investment capital and re- seems possible that—to adversely affect duces the long-run level of real activity. In the financial system—inflation must be addition, when credit rationing is suffi- “high enough.” ciently severe, it induces endogenously Why does inflation affect financial arising volatility in rates of return to sav- markets and real activity this way? We ings. This volatility must be transmitted to produce a theoretical model in which— real activity and, hence, to the rate of in- consistent with the evidence—higher in- flation. Variable inflation therefore neces- flation reduces the rate of return received sarily accompanies high enough rates of by savers in all financial markets. By itself inflation, as we observe in practice. this effect might be enough to reduce sav- This story, of course, does not explain ings and hence the availability of invest- why these effects are strongest at high— ment capital. However, we do not believe and not at low—rates of inflation. The ex- that this explanation by itself is very plau- planation for this lies in the fact that—at sible, for two reasons. First, to explain the low rates of inflation—our analysis sug- nonmonotonicities we have noted, the sav- gests that credit market frictions are poten- ings function would have to bend back- tially innocuous. Thus at low rates of infla- ward. Little or no empirical evidence ex- tion, credit rationing might not emerge at ists to support this notion. Second, almost all, and none of the mechanisms men- all empirical evidence suggests that sav- tioned in the previous paragraph would be ings is not sufficiently sensitive to rates of operative. In this case our economy would 2 The same phenomena we re- return to make this a plausible mechanism act as if it had no financial market frictions. port here occur in the presence for inflation to have large effects. Thus an When this occurs, our model possesses a of a costly state verification alternative mechanism is needed. standard Mundell-Tobin effect that makes problem (Boyd and Smith forth- We present a model in which inflation higher inflation lead to higher long-run lev- coming), or in a model where reduces real returns to savings and, via this els of real activity.3 However, once inflation spatial separation and limited mechanism, exacerbates an informational exceeds a certain critical level, credit ra- communication affect the finan- friction afflicting the financial system. The tioning must be observed, and higher rates cial system (Schreft and Smith forthcoming and 1994). particular friction modeled is an adverse of inflation can have the adverse conse- selection problem in capital markets. How- quences noted above. 3 In particular, in the absence of ever, the specific friction seems not to be Finally, our analysis suggests that a financial market frictions, our central to the results we obtain.2 What is certain kind of “development trap” phe- model reduces to one in which central is that the severity of the financial nomenon is ubiquitous, particularly at higher rates of inflation (easier market friction is endogenous and varies relatively high rates of inflation.4 We often monetary policy) stimulates real output growth. This occurs positively with the rate of inflation. observe that economies whose perfor- in a variety of monetary growth In this specific model, higher rates of mance looks fairly similar at some point models: see Mundell (1965); inflation reduce savers’ real rates of return in time—like Argentina and Canada circa Tobin (1965); Diamond and lower the real rates of interest that 1940—strongly diverge in terms of their (1965); or especially Azariadis borrowers pay. By itself, this effect makes subsequent development. Although (1993) (for an exposition); more people want to be borrowers and this is clearly often because of differences Sidrauski (1967); and Shell, fewer people want to be savers. However, in government policies, presumably many Sidrauski, and Stiglitz (1969). people who were not initially getting governments confront similar policy op- 4 See Azariadis and Drazen credit represent “lower quality borrowers” tions. One would thus like to know (1990) for one of the original or, in other words, higher default risks. In- whether intrinsically similar economies theoretical expositions of devel- vestors will be uninterested in making can experience divergent economic perfor- opment traps. more loans to lower quality borrowers at mance for purely endogenous reasons. F E D E R A L R E S E RV E B A N K O F ST. L O U I S 10 MAY/ J U N E 1 9 9 6 The answer in models with financial mar- tical in its size and composition. We de- ket frictions is that this can occur fairly scribe the latter below and index time pe- easily: When the severity of an economy’s riods by t = 0, 1, ...