The causal effect of inflation on financial stability, evidence from history

In contrast to the conventional Fisherian view that inflation reduces real debt positions, we show that significant increases in inflation are strongly associated with financial crises. In the spirit of Jordà et al. (2020), countries with free and fixed ex-change rates can be compared to difference out the confounding reaction of monetary policy. Across a dataset of 18 advanced economies over 151 years, we show that the impact of inflation extends beyond its indirect effect via monetary policy. To further corroborate causality, we instrument inflation with oil supply shocks, finding that a 1pp rise in inflation doubles the probability of financial crisis from its sample average. We give evidence for the redistribution channel, where inflationary shocks directly cut real incomes, as a possible mechanism. In conjunction with recent literature on the dangers of rapidly tightening monetary policy, our results point to a difficult trade-off for central banks once inflation has risen. JEL Classification: E31, E44, E58, G01