Inflation, real growth, and distortions of corporate decision-making: Evidence from the micro data

Using a large sample of international firms, we study the effects of sustained inflation on corporate decision making. In particular, we attempt to resolve the debate in the literature whether inflation is good or bad for firms. In a companion paper Boyd, Jalal and Porkorny (2014), we theoretically show that high, sustained inflation reduces welfare for economic agents. In this study, we explore how such sustained inflation affects corporate decisions and performance. The relationships we test here are directly based on the predictions of our theory. A key assumption in obtaining that result is that, as average inflation rises, the volatility of inflation rises also. Noise is injected into the contracting process and it becomes more difficult and costly to write contracts calling for payment of a real future sum. We employ three regression techniques. The first, is OLS linear regressions with fixed effects. Second, we use threshold regressions. Finally, we estimate quadratic and cubic regressions. The fundamental hypothesis of this study is that as inflation rises, the macroeconomic environment becomes hostile. Profit margins are eroded and exogenous price risk rises. We find that as inflation goes up, firms are less likely to commit to potentially risky investment in both capital and labor. As inflation increases firms become less profitable (in real terms) and Tobin’s Q falls. We also find the presence of non-linearity in some of these relationships. Our results suggest that sustained high inflation is unlikely to be good for economic development. We explain the channel through which inflation affects economic growth. We show that as inflation increases, it becomes harder for corporations to raise the funding needed to support their growth. This, in turn, affects economic growth of the country.