Inflation and the misallocation of resources

This paper analyzes the effects of inflation on the resource allocation bet ween the financial sector and the manufacturing sector I We develop a model with heterogeneous workers who can be employed either in the manufacturing sector which produces a consumption good, or the financial sector which pr ovides liquidity services.,A rise in inflation reduces the demand for labor in the manufacturing sector and increases the demand for financial service s. This induces a shift of resources from the manufacturing sector to the f inancial sector and reduces consumption opportunities. An empirical investi gation using 55 countries strongly supports the result that higher inflatio n increases the relative size of the financial sector (JEL E).