Inflation and Corruption

Abstract

We present a simple agency model where agents can inflate the price that owners pay for goods needed to start an investment project. High and variable inflation is assumed to increase the cost of monitoring the agent. We then show how this can lead to higher corruption and lower investment in equilibrium. We also document a positive relationship between corruption and inflation variability in a sample of 75 countries over 14 years. The effect is robust to the inclusion of country fixed effects, 2SLS estimation and variables that are used to proxy for other theoretically plausible influences on corruption. The panel estimates we derive are economically significant: a one standard deviation increase in inflation variance from the median can lead to an increase in corruption of 12-percent of a standard deviation and a decline in growth rates of 0.33 percentage points. Our paper highlights a new channel through which inflation reduces investment and growth, and can help understand the discrepancies over the costs of inflation between economists and the general public. We also find evidence that political competition reduces corruption and that corruption is pro-cyclical. JEL: K42