Inflation and Endogenous Technological Growth

The paper develops a Romer-type growth model with a research sector, a manufacturing sector, and a financial sector and shows that inflation has an adverse effect on economic growth. Higher inflation increases the incentives for agents to use money substitutes through financial services in an attempt to reduce inflation tax. This increases the size of the financial sector and shifts resources out of other sectors of the economy including research, the engine of growth, into the financial sector. As a consequence, the economy-wide growth rate declines. The paper examines the empirical evidence using panel data of 17 countries which have experienced medium or high inflation. The results strongly support the hypothesis of the expansionary effect of inflation on the size of the financial sector and the negative effect of inflation on growth.Inflation, Growth, Resource Allocation