Institut für Höhere Studien (IHS), Wien 
Institute for Advanced Studies, Vienna

Reihe Transformationsökonomie / Transition Economics Series No. 13
December 1999

View full text: te-13.pdf
Inflation, Growth, and Credit Services

Max Gillman, Michal Kejak, Ákos Valentinyi

Institut für Höhere Studien
Stumpergasse 56, A-1060 Wien
Fax: +43/1/599 91-163

Max Gillman

Department of Economics
Central European University
Nador ut. 9
H-1051 Budapest, HUNGARY
Phone: +36/1/327-3227
Fax: +36/1/327-3232

Michal Kejak

Politickych veznu 7
CZ-111 21 Prague 1, CZECH REPUBLIC
Phone: +420/2/2400-5186
Fax: +420/2/2422-7143
Institute for Advanced Studies, Vienna

Ákos Valentinyi

Department of Economics
University of Southampton & CEPR
Southampton SO17 1 BJ, UNITED KINGDOM
Phone: +44/1703-595000
Fax: +44/1703-593939

Institut für Höhere Studien (IHS), Wien

Institute for Advanced Studies, Vienna
The Institute for Advanced Studies in Vienna is an independent center of postgraduate training and research in the social sciences. The publication of working papers does not imply a transfer of copyright. The authors are fully responsible for the content.
The empirical evidence suggests that there is a significant, negative relationship between inflation and economic growth. Conventional monetary growth models, however, predict a significantly smaller growth effect. This paper proposes a monetary growth model with an explicit credit service sector to explain the observed magnitude. Since credit services are assumed costly to produce, the consumers equate the opportunity cost of holding money with the marginal cost of credit. Therefore the technology of the financial sector influences the velocity of money, and consequently, how inflation affects leisure, the time spent accumulating human capital, and the growth rate of output. The calibration shows that the model generates an inflation-growth effect whose magnitude falls in the range found by the empirical studies. Moreover, in contrast to previous works, we are also able to explain an inflation-growth effect that becomes increasingly weak as the inflation rate rises, as the evidence seems to suggest. Analysis of the welfare cost of inflation further illuminates the inflation-growth effect and how the model compares to the literature.


Economic growth, inflation, costly credit
JEL Classifications
O11, E31
We are grateful to participants at the 1999 Midwest Spring Macroeconomics Conference at seminars at the three affiliate institutions of the authors, and Michal Pakos for helpful comments, and to Krisztina Molnár for excellent research assistance. The first two authors kindly acknowledge support from the Institute for Advanced Studies in Vienna, and the last author from the European Union's Phare ACE programme 1996, P96-6158-R.


1. Introduction   1

2. Inflation and Growth: Evidence and Theory   2
3. Economic Environment   7
4. Balanced Growth Path   9
4.1 Competitive Equilibrium   9
4.2 Credit Services and Money Demand   11
5. Balanced Growth Path: The Log-utility Case   12
5.1 Consumption, Leisure, and the Growth Effect of Inflation   13
5.2 Interest Elasticity and the Growth Effect of Inflation   15
5.3 The Welfare Cost of Inflation and the Cost of Credit Services   18
6. Calibration   20
7. Conclusions and Qualifications   23
Appendix A: Equivalence of Explicit and Implicit Banking
Sectors   26
Appendix B: The Existence of the Balanced-growth Equilibrium   29
6. References   32