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Date Submitted: 05/21/2012 01:42 PM
The Impact of Inflation on Financial Sector Performance*
John H. Boyd
Carlson School of Management, University of Minnesota, Minneapolis, MN 55455, USA
Ross Levine
Carlson School of Management, University of Minnesota, Minneapolis, MN 55455, USA
Bruce D. Smith
Department of Economics, University of Texas-Austin, Austin, TX 78712, USA February 2000 Abstract: A growing theoretical literature describes mechanisms whereby even predictable increases in the rate of inflation interfere with the ability of the financial sector to allocate resources effectively. This paper empirically assesses these predictions. The evidence indicates that there is a significant, and economically important, negative relationship between inflation and both banking sector development and equity market activity. Further, the relationship is nonlinear. As inflation rises, the marginal impact of inflation on banking lending activity and stock market development diminishes rapidly. Moreover, we find evidence of thresholds. For economies with inflation rates exceeding 15 percent, there is a discrete drop in financial sector performance. Finally, while the data indicate that more inflation is not matched by greater nominal equity returns in low-inflation countries, nominal stock returns move essentially onefor-one with marginal increases in inflation in high-inflation economies. Key Words: Banks; Financial Markets; Inflation JEL Classification: G2, G1, E31
* Corresponding author: John H. Boyd, jboyd@csom.umn.edu. We would like to thank David Arseneau and Michelle Barnes for outstanding research assistance and seminar participants at the Financial Markets Group, London School of Economics, the National Institute for Economic and Social Research, the University of Southern California, UCLA, the University of Texas, Chinese University of Hong Kong, IGIER-Bocconi, the 1997 meetings of the Society for the Advancement of Economic Theory, the World Bank, and the Western Finance Association,...