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Inflation and indivisible investment in developing economies

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  • Eden, Maya
  • Nguyen, Ha

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.

Suggested Citation

  • Eden, Maya & Nguyen, Ha, 2014. "Inflation and indivisible investment in developing economies," Policy Research Working Paper Series 6972, The World Bank.
    • Handle: RePEc:wbk:wbrwps:6972
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    References listed on IDEAS

    as
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    Keywords

    Investment and Investment Climate; Debt Markets; Economic Theory&Research; Access to Finance; Non Bank Financial Institutions;
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