“Inflation is the one form of taxation that can be imposed without legislation.” – Milton Friedman.
Imagine a scenario where a country is experiencing a significant increase in inflation rates. Prices of goods and services are rising rapidly, and people are starting to feel the pinch in their daily lives.
This surge in inflation has ignited a heated debate among economists regarding its impact on the country’s overall economic growth. Different schools of thought provide contrasting viewpoints on this matter, shaping the ongoing discussion in macroeconomics.
According to the classic perspective of the “neutrality of money,” increases in inflation have minimal impact on real gross domestic product (GDP) since inflation affects both prices and wages proportionally, essentially changing the measurement units.
Another viewpoint suggests that rising inflation is not the cause of sluggish economic growth but rather a symptom of underlying economic issues such as supply-side disruptions or fiscal imbalances.
On the other hand, certain macroeconomic theories, like New Keynesian theories, propose that increasing inflation can temporarily boost real GDP, given specific conditions. However, these theories struggle to explain the occurrence of stagflation, which is characterized by high inflation and slow economic growth happening simultaneously.
Numerous studies have delved into a crucial aspect of the banking sector, namely the relationship between asset-liability mismatch and inflation. When inflation rates rise, the asset-liability mismatch can have detrimental effects on a bank’s equity and net interest margins.
Consequently, this can lead to a reduction in lending to households and businesses. A research paper titled “Inflation and Disintermediation” (Agarwal and Baron 2023) introduces a novel metric to gauge the extent of each bank’s asset-liability mismatch in the face of increasing inflation.
This measure goes beyond a simple interest rate sensitivity assessment. Even without tighter monetary policies or higher policy rates, the balance sheets and cash flows of banks are still influenced by inflation expectations, resulting in market-driven adjustments to nominal lending rates, deposit rates, and long-term bond yields.
In the previously mentioned research, the researchers have uncovered two initial findings that provide support for their hypothesis regarding the contractionary impact of rising inflation on bank lending.
Firstly, through an analysis of a comprehensive dataset encompassing 47 developed and emerging economies from 1870 onwards, they observed a correlation between inflation increases and short-term declines in the aggregate bank credit-to-GDRP ratio of a country.
Secondly, by examining historical inflation episodes and utilizing bank-level data, including instances such as Germany’s hyperinflation in the 1920s and inflation episodes in emerging economies in recent decades, they found that the contraction in lending primarily affects banks with greater exposure to inflation, as measured by our bank-level inflation exposure metric.
In order to establish a causal relationship between increasing inflation and the impact on the lending capabilities of the banking sector, the team of researchers conducted an analysis of a natural experiment that took place in the United States in early 1977.
This experiment involved a one-time rise in the inflation rate from 5% to 7%, which then remained stable for the following year before experiencing a more rapid increase starting in mid-1978.
Their natural experiment exploits the “random” variations in reserve requirements for Federal Reserve nonmember banks across different states during the 1970s. State-chartered banks adhered to reserve requirements set by their state regulators.
As reserve requirements primarily stipulate a minimum ratio of non-interest-bearing cash to demand deposits, we demonstrate that higher reserve requirements significantly increase the exposure of nonmember banks to inflation.
This is due to the fact that the real value of non-interest-bearing cash is eroded when inflation unexpectedly rises. Consequently, variations in reserve requirements across states result in differences in inflation exposure for nonmember banks.
On the other hand, member banks operate under uniform reserve requirements set at the national level by the Federal Reserve, thus serving as a control group.
They anticipated no systematic differences in inflation exposure among member banks across states.
They analyzed this natural experiment using a two-stage instrumental variables framework as follows. In the first stage, they demonstrated that nonmember banks with higher state-level reserve requirements exhibit higher inflation exposure, as indicated by their bank-level measure of inflation asset-liability mismatch.
In contrast, member banks (the control group) observed no impact on inflation exposure.
Moving on to the second stage of their analysis, they found that banks with the highest inflation exposure experience the most significant reduction in lending following the inflation increase.
Their estimates suggest that overall loan growth in the United States decreased by 3.2 percentage points due to higher inflation, in comparison to the average loan growth of 19% in 1977.
They found that banks with high inflation exposure primarily reduce residential mortgage lending, which subsequently affects house price growth and construction employment in affected states.
Other employment sectors do not observe these effects. Their findings indicated that the contraction in credit supply, triggered by inflation, primarily impacts the housing sector, aligning with a significant body of literature highlighting the strong influence of banking channels on construction employment and housing.
All in all, their research demonstrates that unexpected increases in inflation tend to have a contractionary effect on the banking sector. Banks exposed to inflation respond by reducing lending, which subsequently impacts house prices and construction employment. These findings suggest the potential for rising inflation to generate financial instability, particularly following substantial and unforeseen inflationary spikes.
Moreover, their analysis of historical and international inflation episodes underscores the significance of banking channels in comprehending the global repercussions of inflation.
By shedding light on the relationship between inflation and economic growth, their research contributes to a better understanding of the macroeconomic implications of inflation and its effects on the banking sector.
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