Inflation, Credit Market and Economic Growth

This paper presents a model which predicts a negative, non‐linear relationship between the rate of inflation and rate of output growth, as observed in many empirical studies. The model describes an economy in which credit market imperfections arise due to asymmetric information between lenders and borrowers. Within this environment, two types of lending regime are possible—a rationing regime, where high and low risk borrowers are separated by means of credit rationing, and a screening regime, where separation takes place through costly information acquisition. An increase in the inflation rate alters lenders' behaviour in such a way (by increasing the incidence of rationing or the level of costly screening, or by switching the lending regime from screening to rationing) that adverse growth effect of inflation is magnified. The analysis provides a basis for the empirical finding that growth effect of inflation may be strongest in some specific range of inflation.