Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/129726
Authors: 
Finocchiaro, Daria
Lombardo, Giovanni
Mendicino, Caterina
Weil, Philippe
Year of Publication: 
2015
Series/Report no.: 
Sveriges Riksbank Working Paper Series 311
Abstract: 
This paper revisits the equilibrium and welfare effects of long-run inflation in the presence of distortionary taxes and financial constraints. Expected inflation interacts with corporate taxation through the deductibility of i) capital expenditures at historical value and ii) interest payments on debt. Through the first channel, inflation increases firms' taxable profits and further distorts their investment decisions. Through the second, expected inflation affects the effective real interest rate negatively, relaxes firms' financial constraints and stimulates investment. We show that, in the presence of collateralized debt, the second effect dominates. Therefore, in contrast to earlier literature, we find that when the tax code creates an advantage of debt financing, a positive rate of long-run inflation is beneficial in terms of welfare as it mitigates the financial distortion and spurs capital accumulation.
Subjects: 
optimal monetary policy
Friedman rule
credit frictions
tax benefits of debt
JEL: 
E31
E43
E44
E52
G32
Document Type: 
Working Paper

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