Thursday, October 2, 2014

The disproportionate impact of inflation on small firms

Here is an abstract from a recent WB working paper that argues that inflation disproportionately reduces investment by small firms, which obviously have lower cash flows, because it erodes the value of their accumulated savings (= investment eventually).

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.