SAVINGS, INVESTMENT, EMPLOYMENT, AND INFLATION IN A SMALL OPEN ECONOMY WITH HABIT PERSISTENCE

The effects of inflation are studied for a small open economy with a cash-in-advance constraint on consumption in which the representative agent has preferences with habit persistence. An increase in the inflation rate requires a fall in the steady state living standards. On impact, to maintain living standards, the representative agent reduces his savings and labor supply. Investment falls and the current account turns into a deficit. In support of this model, we provide evidence from eight high-inflation countries suggesting that after an increase in the inflation rate, output and investment fall, and the net foreign asset position deteriorates over time.