Inflation, Financial Development, and Economic Growth

Abstract

A simple endogenous growth model is developed to illustrate the important role played by inflation in determining the effects of financial development on economic growth. In the model, money is needed for loan transactions and the operations of financial markets are subject to informational imperfections. Results demonstrate that if a government`s spending share is relatively large, then multiple equilibria arise under which financial development, measured by a decrease in the monitoring cost, is shown to raise inflation and reduce economic growth for countries with relatively high initial inflation rates. Only when initial inflation rates are relatively low will financial development reduce inflation and promote growth. Effects of an expansion policy in which the government raises its spending share on equilibrium inflation and economic growth are also examined.