When firms finance using long-term nominal debt issued by financial intermediaries, changes in expected inflation lead to a wealth transfer across sectors. Higher expected inflation decreases firms’ real liabilities and default risk, which helps reduce debt overhang. However, it hurts intermediaries’ real assets, leading to a contraction in credit supply. We theoretically demonstrate that intermediary financing conditions play a key role in the transmission of nominal shocks, influencing the premium investors require for bearing inflation risk. We provide empirical evidence supporting our novel inflation transmission mechanism and connect our findings to the banking stress of 2023. We also show that Taylor rules responding to both financial and real variables can help stabilise our economy.

ABSTRACT We develop a unified theory of dynamic contracting and assortative matching to explain firm dynamics. In our model, neither firms nor managers can commit to arrangements that yield lower payoffs than their outside options, which are microfounded by the equilibrium conditions in a matching market. The model endogenously generates power laws in firm size and CEO compensation, and explains differences in their right tails. We also show that our model quantitatively accounts for many salient features of the time‐series dynamics and the cross‐sectional distribution of firm investment, dividend payout, and CEO compensation.