Inflation Risk and the Finance-Growth Nexus

2024-05-07 11:49:44

When firms finance using long-term nominal debt issued by financial intermediaries, changes in expected inflation lead to wealth transfer across sectors. Higher expected inflation decreases firms' real liabilities and default risk, which helps reduce debt overhang. However, it hurts intermediaries' real assets, leading to a contraction in credit supply. We theoretically demonstrate that financing conditions play a key role in the transmission of nominal shocks, influencing the premium investors require for bearing inflation risk. We provide empirical evidence supporting our novel inflation transmission mechanism. We also show that an inflation policy responding to both financial and real variables can help stabilize our economy.

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