How Inflation Affects Banking
May 15, 2006
Federal Reserve Bank of Cleveland
Inflation, Banking, and Economic Growth by John H. Boyd and Bruce Champ
B
y now, everybody knows inflation is bad. Hyperinflations—when inflation rates are extremely high—are the horror stories, but few doubt the harmful effects of inflation rates in the teens either. Over the past several decades, central banks around the world have been pretty successful at dramatically lowering inflation rates. Can we now stop worrying about inflation? Probably not. There is good reason to believe that inflation is harmful even at what one might consider relatively moderate rates—annual rates of perhaps 5 to
10 percent.
The evidence of this claim began to accumulate in the mid-1990s. At the time, most economists believed that, under certain conditions, inflation could be a good thing. Their theories suggested that inflation spurred increases in output. But in 1995, Robert J. Barro published findings that suggested otherwise. He studied many economies and found that, across countries, inflation and economic growth were negatively related—higher inflation was associated with lower economic growth.
Roughly around the same time, other economists were revealing the essential role that financial intermediaries play in economic development. These two discoveries led others to suggest a connection between inflation, financial intermediaries, and economic growth.
In particular, they speculated that the way inflation hurt economic growth was by interfering with the role financial intermediaries play in an economy.
Since then, theories have been advanced to explain the connection. These theories suggest that inflation may damage financial markets or impede their smooth
ISSN 0428-1276
operation. This Economic Commentary discusses these theories and presents some new empirical findings that provide further support for them.
■
Theoretical Insights into Inflation
A key insight of the recent theories is that inflation exacerbates so-called
Federal Reserve Bank of Cleveland
Inflation, Banking, and Economic Growth by John H. Boyd and Bruce Champ
B
y now, everybody knows inflation is bad. Hyperinflations—when inflation rates are extremely high—are the horror stories, but few doubt the harmful effects of inflation rates in the teens either. Over the past several decades, central banks around the world have been pretty successful at dramatically lowering inflation rates. Can we now stop worrying about inflation? Probably not. There is good reason to believe that inflation is harmful even at what one might consider relatively moderate rates—annual rates of perhaps 5 to
10 percent.
The evidence of this claim began to accumulate in the mid-1990s. At the time, most economists believed that, under certain conditions, inflation could be a good thing. Their theories suggested that inflation spurred increases in output. But in 1995, Robert J. Barro published findings that suggested otherwise. He studied many economies and found that, across countries, inflation and economic growth were negatively related—higher inflation was associated with lower economic growth.
Roughly around the same time, other economists were revealing the essential role that financial intermediaries play in economic development. These two discoveries led others to suggest a connection between inflation, financial intermediaries, and economic growth.
In particular, they speculated that the way inflation hurt economic growth was by interfering with the role financial intermediaries play in an economy.
Since then, theories have been advanced to explain the connection. These theories suggest that inflation may damage financial markets or impede their smooth
ISSN 0428-1276
operation. This Economic Commentary discusses these theories and presents some new empirical findings that provide further support for them.
■
Theoretical Insights into Inflation
A key insight of the recent theories is that inflation exacerbates so-called