The Role of Search Frictions in the Long-Run Relationship Between Inflation and Capital

This paper explores the long-run relationships among inflation, capital accumulation and unemployment. We find that in the U.S. data, inflation and the capital to output ratio are positively correlated, while in a cross-section of 49 countries, a non-monotonic relationship exists between inflation and the investment to output ratio. To reconcile these empirical findings, we propose a general equilibrium framework with frictions in both labor and goods markets. This framework allows us to highlight the following two channels through which monetary policy affects capital accumulation: extensive and intensive margins. Due to the opposing effects on these two margins, our model predicts that an inverted U-shaped relationship exists between inflation and capital in the long run. The nonlinearity identified by our model strongly contrasts previous findings suggesting either a positive or a negative correlation between money and capital. Our work provides novel insight into a classical issue.