Devaluation, Asymmetric Money Demand, and Investment in a Small Open Economy

This paper investigates the relationship between inflation and investment when cash is required to purchase some consumption goods in a small open economy while others are purchased with foreign currency or on credit. Devaluation acts as a differential tax on the good that must be purchased with domestic money and lowers the return to the factor used intensively in this sector. If this sector is relatively labor intensive, the steady-state capital stock will increase in response to higher inflation. Nonneutrality of inflation exists even though money is only held for consumption purposes.