Inflation, investment and economic performance: The role of internal financing

This paper studies a link between inflation and economic activity that is built on two hypotheses. First, firms mitigate informational frictions in financial markets by accumulating retained earnings over a period of time. Second, firms allocate earnings among three competing uses – dividends, current investment, and the accumulation of internal funds – and inflation directly distorts this allocation decision as well as the real value of accumulated internal funds. The model predicts that the level of inflation – both unanticipated and expected inflation – as well as the variability of inflation distort firms’ internal financing decisions, increases frictions in financial markets, reduces the level and efficiency of investment, and reduces aggregate output. The marginal effects of inflation are increasing in the inflation rate.