In this paper we build an endogenous growth model in which the informal economy is subject to a cash‐in‐advance constraint along with physical capital accumulation and consumption. In this setting, we find that inflation generally adversely affects long‐run growth. However; this effect strongly interacts with the size of the informal economy. Specifically, the negative effect becomes milder (and can even be positive) under the presence of a large informal economy. Moreover, using an annual cross‐country panel data set of 161 countries over the period 1950‐2010 we also provide some empirical support for the mechanism of our theory.