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Inflation, Real Activity and Income Distribution

This paper develops a monetary growth model in which inflation affects credit market efficiency, and via this link, capital accumulation, and the incomes of agents. Some fraction of the population is capitalists, who have access to a risky but high return capital production technology. Capital investment must be partially externally financed via workers' savings, and this is subject to a costly state verification (CSV) problem. Successful capitalists leave bequests to their offspring which are then used by them to internally fund some part of their own investment projects. Bequests help mitigate the severity of the contracting friction thereby promoting credit market efficiency and capital formation. Inflation acts as an unavoidable tax on the capital incomes of the capitalists thereby reducing their bequests and worsening the CSV friction. The computational experiments reveal that in the model economy, irrespective of whether the government rebates the proceeds of the inflation tax to capitalists or workers, inflation increases the steady-state capital stock. The regime where workers get the entire transfer is shown to be "superior" in many respects to one where the capitalists get some or all the transfer.