Inflation, financial markets and long-run real activity

Empirical evidence suggests that real activity, the volume of bank lending activity, and the volume of trading in equity markets are strongly positively correlated. At the same time, inflation and financial market activity are strongly negatively correlated (in the long run), as are inflation and the real rate of return on equity. Inflation and real activity are also negatively correlated in the long run, particularly for economies with relatively high rates of inflation. We present a monetary growth model in which banks and secondary capital markets play a crucial allocative function. We show that - at least under certain configurations of parameters - the predictions of the model are consistent with these and several other observations about inflation, finance and long-run real activity. (C) 1999 Elsevier Science B.V. All rights reserved. JEL classification: E5; E6; G2.