Although the effects of inflation on economic activity and welfare have been studied extensively, there is still considerable controversy about the mechanisms through which inflation affects economic performance. One issue that has received little attention but that seems to be well known to practitioners is the effects of inflation on the operation of financial markets, in particular, on their ability to channel funds to the most efficient activities.
This paper develops a formal model that links inflation and financial markets. The model is based on the premise that, as inflation rises, banks have more difficulty distinguishing the riskiness of different customers because risky customers must behave like safe customers in order to receive better credit terms. The model has two types of firms: one is less productive and has a positive probability of default, while the other is more productive and does not default. It is argued that inflation increases the similarity between the two types of firms, either because the productivity of safe firms declines with inflation, or, owing to higher search costs, because the demand of riskier firms increases relative to that of safe firms.
When inflation is low, a fully revealing equilibrium prevails, in which banks can perfectly identify each type of firm. However, as inflation rises, low-productivity firms have more incentive to behave like high-productivity firms because the costs of mimicking this behavior decline. In contrast, high-productivity firms have less incentive to signal their type because signaling costs increase. Thus, high inflation may induce a pooling equilibrium in which banks are unable to distinguish between the two types of firms.
The links between inflation and financial markets discussed in this paper are potentially relevant for a number of reasons. First, they may provide new insight into the effects of inflation on economic growth. The inability of financial intermediaries to distinguish the riskiness associated with different customers may have consequences for the ability of financial markets to allocate credit and foster economic growth. Second, they may help explain the marked recovery of credit to the private sector after the successful implementation of a stabilization program, which induces an increase in economic activity.