This paper uses an intertemporal optimizing model with country‐specific risk premium to evaluate the real effects of inflation in a small open developing economy. In the model, a central bank targets inflation, and the consumer requires real balances in advance for consumption spending. We show that a positive inflation shock (either due to growth in money supply or depreciation of the domestic currency) yields a decrease in real output and consumption—as inflation creates a tax wedge in the intratemporal condition between consumption and leisure—leading to a decrease in the stock of real debt in domestic currency. Employing these theoretical predictions and using annual data from a set of six developing countries (Chile, Ghana, Indonesia, Kenya, Malaysia and Thailand), we estimate a sign‐restriction based structural vector autoregression model along with a panel vector autoregression model for robustness analysis. The empirical results support the trade‐off of inflation with reference to the key real variables including the external debt position, which is a significant result given the ambiguity in the empirical literature as to whether governments can escape from debt crisis via higher inflation. Copyright © 2016 John Wiley & Sons, Ltd.