Finance and Economics Discussion Series (FEDS)
July 1997
Inflation and Financial Sector Size
Abstract:
Traditionally the cost of expected inflation has been seen as the “shoeleathercost” of going to the bank more often. This paper focuses on the other side of these transactions--i.e., on the increased production of financial services by financial firms. I construct a model in which households must make purchases either with cash or with costly transactions services produced by firms in the financial services sector. One can think of these services as being the use of a credit card or other method of paying without cash. In the model, a higher inflation rate leads households to substitute purchased transactions services for money balances. As a result, the financial services sector gets larger. A test of the model using cross-sectionaldata finds that the size of a nation’s financial sector is strongly affected by its inflation rate. The empirical results provide an alternativeway to measure the costs of inflation. These costs appear to be large.
Keywords: Inflation, transactions services, financial sector, money demand
PDF: Full Paper
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