On the Nonlinear Relationship between Inflation and Growth: A Theoretical Exposition

Abstract

This study introduces cash-in-advance constraints into an R&D-based model of endogenous growth in which agents' abilities to develop new goods are heterogeneous. We demonstrate that the negative effect of inflation on long-term growth is weaker in the heterogeneous ability economy than in the homogeneous ability economy if the inflation rate is relatively low, whereas the opposite outcome holds in the high inflation regime. Our numerical examples show that the threshold level of inflation is about 20% per year, which fits well with the findings of existing empirical studies of the nonlinear relation between inflation and growth.