This paper analyzes the effects of inflation on the resource allocation between the financial sector and the manufacturing sector. We develop a model with heterogeneous workers who can be employed either in the manufacturing sector, which produces a consumption good, or the financial sector, which provides liquidity services. A rise in inflation reduces the demand for labor in the manufacturing sector and increases the demand for financial services. This induces a shift of resources from the manufacturing sector to the financial sector and reduces consumption opportunities. An empirical investigation using 55 countries strongly supports the result that higher inflation increases the relative size of the financial sector. Copyright 2000 by Oxford University Press.
