On the employment, investment and current account effects of inflation: A revisit

Abstract

This paper supplements the studies of Mansoorian and Mohsin (2004, 2006) on the macro effects of a temporary policy of inflation targeting by shedding light on two neglected scenarios. These scenarios are not only empirically plausible, but also give rise to rather different policy implications. First, we show that if consumption and leisure are substitutes and their substitutability is relatively large, a temporary rise in inflation can raise, rather than lower, the shadow value of assets. This effect stemming from the rise in the shadow price of assets plays a crucial, but opposite, role vis-à-vis the direct effect of inflation. The induced effect of the shadow price is long-lasting persistence and has a permanent consequence, even though the policy is temporary. As a result, in the steady state, employment, capital, and output increase, rather than decrease, in response to a temporary increase in inflation. Second, if consumption and leisure are complements, we find that in response to a temporary decrease in inflation, employment, capital and output suffer short-run costs in the transition, but reap long-run benefits in the steady state. This transitional result is in accordance with the Canadian responses.