Joint with Macro - Financial Phillips Curve and the German Hyperinflation

Abstract

Unexpected inflation redistributes wealth toward equity owners of highly levered firms. In the presence of financing frictions, such redistribution can impact the allocation of real activity. We use the German inflation of 1919-1923 as a laboratory to study how a large and unexpected inflation is transmitted to the real economy through firm balance sheets. At the aggregate level, the German inflation resulted in a large decline in leverage and real interest expenses of non-financial firms. As a result, there is a tight negative relation between firm bankruptcies and inflation, a ``Financial Phillips Curve.'' Using newly digitized firm-level data, we document that firms with higher leverage at the onset of the inflation see a larger subsequent decline in leverage, faster growth in real book equity, and higher risk-adjusted market equity returns. More levered firms increase investment and employment, consistent with substantial real effects of the inflation through firm balance sheets.