Inflation and Indivisible Investment in Developing Economies

35 Pages Posted: 20 Apr 2016

See all articles by Maya Eden

Maya Eden

World Bank - Development Research Group (DECRG)

Ha Nguyen

International Monetary Fund (IMF)

Date Written: July 1, 2014

Abstract

In countries with limited access to finance, firms accumulate retained earnings to finance indivisible investment projects. McKinnon (1973) illustrates that when cash is used as a primary store of value, inflation may discourage investment as it increases the cost of accumulating retained earnings. This paper formalizes this argument in a dynamic framework and provides a simple calibration of the model that suggests sizable effects of inflation on investment. The mechanism is particularly relevant for small firms, as firms with lower cash flows must accumulate retained earnings for longer periods of time to meet the price of indivisible investment goods. Consistent with the model, empirical evidence suggests that inflation disproportionately reduces investment in small firms.

Keywords: Capital Markets and Capital Flows, Inflation, Capital Flows

Suggested Citation

Eden, Maya and Nguyen, Ha, Inflation and Indivisible Investment in Developing Economies (July 1, 2014). World Bank Policy Research Working Paper No. 6972, Available at SSRN: https://ssrn.com/abstract=2470232

Maya Eden (Contact Author)

World Bank - Development Research Group (DECRG) ( email )

1818 H. Street, N.W.
MSN3-311
Washington, DC 20433
United States

Ha Nguyen

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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