Inflation, investment decisions and the Fisher Effect

The relationship between interest rates and inflation has been dealt with extensively in the literature. In this paper we show that even in the simple case of a world with no taxes, inflation has a real effect on macro-economic variables. For this case, we show that both the real interest rate and the investment size will decline with inflation. This result is based on the added risk of relative-price uncertainty for investors who invest in one good. This risk can be diversified for the individual investor by holding a portfolio of several firms in which the relative price risk can be substantially reduced. One implication of our analysis is that the risk associated with inflation can explain the real effect of inflation on output as well as the negative association between inflation and stock prices.