# Discussion Paper

## Abstract

Theoretical models point at various channels of the impact of inflation on corporate investment. This article attempts to answer the question what are the direction and strength of this possible impact examining the relationship between corporate investment and inflation on the sample of 21 OECD countries in the years 1960-2005. The obtained negative relationship, statistically and economically significant, proves robust to changes in the specification of the estimated equation, estimators, frequency of variables used in the study and analysed period. Moreover, the results obtained suggest nonlinear character of this relationship: marginal effect on corporate investment is higher at inflation rates between 3 and 5.5 per cent. These results suggest that the impact of inflation on corporate investment dynamics may be the source of nonlinear nature of the relationship between GDP growth and inflation identified in previous empirical studies. Finally, taking into account the direct impact of inflation on investment, variables approximating the cost of capital utilisation prove to be statistically insignificant determinants of corporate investment.

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## Assessment

# Comments and Questions

I find the paper inspiring and informative.

Among its strengths I would underline the following ones: (1) the paper is well rooted in theoretical and empirical literature, which is reflected e.g. in the careful process of selecting the specification of the model applied; (2) the study takes
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into consideration a possibility of non-linear effects in the relationship between inflation and investment; (3) there Authors check the robustness of the results.

I have the following suggestions that could contribute to completing the robustness check: (1) among explanatory variables the Authors could try include a measure of the development of the financial intermediation system (some studies find measures of this kind very useful in explaining investment); (2) the Authors could check whether other characteristics of inflationary processes, such as its volatility (measured with standard deviation or coefficient of variation), are not more important in explaining investment than the means.

As far as the policy considerations are concerned, it seems to me that it is not fully appropriate to treat the results of the study as a counterbalance to the fears that tightening of monetary policy can discourage firms from investing. The study results concern long-term relationship, the fears of monetary policy being too tight refer to short/medium-term effects. Depending on monetary policy actions it is possible to have the same level of long-term inflation with combinations of output volatility and inflation volatility sizeably different.

Thank you very much for insightful comments.

We find your suggestion concerning robustness check enhancement as very useful however to our best knowledge there is no dataset available which includes variables you mentioned and covers the years 1960-2005. On the other hand theoretical models (e.g. Sheshinski and Weiss (1977), Rotemberg
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(1983), Lucas (1972), Barro (1976), Hercowitz (1981)) as well as empirical studies (see Nautz and Scharff (2005) and Mizena and Russella (2007)) indicate that inflation causes relative price variability which in our opinion justifies including inflation rather than inflation variability in our model.

Regarding the second issue we agree that inflation exerts the impact on corporate investment mostly in the long-term. However some of the channels e.g. inflation-uncertainty-investment may cause also short-term effects.

This paper examines the impact of CPI inflation on investment in 21 OECD countries between 1960-2005. It identifies three channels through which inflation may affect investment, viz., asymmetry of information, uncertainty and rigidities of the tax system. While this is well taken the approach suffers from two serious omissions. First, ...[more]

... the most obvious impact of inflation on investment is through the Fisher equation whereby a rise in inflation raises the interest rate and hence the cost of capital. This is not modeled. Second, the three factors mentioned above are not systematically integrated into the investment equation estimated.

Hence, I cannot recommend acceptance of this paper.

Thank you for your comments. Unfortunately we can not agree with any of them.

As regards to the first argument: We are fully aware of the relation described by the Fisher equation and the fact that the cost of capital is one of the possible determinants of firms investment ...[more]

... decisions. To approximate changes in the cost of capital utilisation and their impact on investment we included relative price of capital goods and nominal long-term interest rate as explanatory variables in the estimated investment equation. On the page 7 we explained the reasons why we included nominal rather than real interest rate:

“Obviously, the cost of capital depends on the real, rather than nominal interest rate. In most empirical research, however, the real interest rate is determined in a simplified manner, i.e. by subtracting the current inflation rate from the nominal interest rate. As in the analysed model the rate of inflation is already present as a separate explanatory variable, including it for the second time as a discounting factor would distort the interpretation and relevance assessment of the relationship between inflation and investment. In turn, the calculation of the real interest rate in a correct way consisting in accounting for the expected, rather than current inflation, is not possible due to the lack of relevant data.”

Moreover, your assumption that “the most obvious impact of inflation on investment is through the Fisher equation whereby a rise in inflation raises the interest rate and hence the cost of capital” is not necessarily true. As we stressed on the page 7 economists come across serious problems with empirical confirmation of the dependency of investment on the cost of capital (see e.g. Blanchard, 1986 or Baddeley, 2003 for a review). Our study also do not confirm that variables approximating the cost of capital utilisation are statistically significant determinants of corporate investment.

As regards to the second argument: As we stressed in the Introduction (page 2) the aim of the paper is to analyse whether inflation exerts any significant impact on corporate investment and what the direction and the strength of this possible impact are. That is why we opted for an approach based on reduced model when selecting the estimation strategy. On the page 7 we explained why we do not model directly the impact of particular channels on corporate investment:

“On the one hand, we are not aware of any theoretical model accounting for all the impact channels described in Section 2 that could constitute the basis for estimating a structural model. It is true that an estimation of several structural models, each of them taking into account a number of the existing channels of influence, could be an alternative to a reduced model. However, this would not allow us to account for the interactions between individual channels, and would also preclude a consistent assessment of their relative significance. Therefore, it would be impossible to achieve the main benefit that structural models should provide, namely, a clear and consistent interpretation of the results.

On the other hand, the purpose of this study is to identify the direction and strength of the combined impact of inflation on corporate investment, which is the resultant of all the previously described effects, rather than the identification of particular mechanisms and fine-tuning them to the best theoretical model.”

Once again thank you for your comments

Piotr Cizkowicz and Andrzej Rzonca