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Uncertainty, Inflation, and Welfare

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  • JONATHAN CHIU
  • MIGUEL MOLICO

Abstract

This paper studies the welfare costs and the redistributive effects of inflation in the presence of idiosyncratic liquidity risk, in a micro-founded search-theoretical monetary model. We calibrate the model to match the empirical aggregate money demand and the distribution of money holdings across households, and study the effects of inflation under the implied degree of market incompleteness. We show that in the presence of imperfect insurance the estimated long-run welfare costs of inflation are on average 40% smaller compared to a complete markets, representative agent economy, and that inflation induces important redistributive effects across households. For example, the welfare gains of reducing inflation from 10% to 0% is 0.59% of income. Furthermore, we estimate that the long-run welfare gains of reducing the typical current inflation target of 2 to 1 percent to be 0.06% of income.

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File URL: http://hdl.handle.net/10.1111/j.1538-4616.2011.00448.x
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Bibliographic Info

Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 43 (2011)
Issue (Month): (October)
Pages: 487-512

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Handle: RePEc:mcb:jmoncb:v:43:y:2011:i::p:487-512

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Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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References

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  1. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2000. "Money, interest rates, and exchange rates with endogenously segmented markets," Staff Report 278, Federal Reserve Bank of Minneapolis.
  2. Huberto M. Ennis, 2005. "Avoiding the inflation tax," Working Paper 05-10, Federal Reserve Bank of Richmond.
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  4. Stephen D. Williamson, 2006. "Search, Limited Participation, And Monetary Policy ," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(1), pages 107-128, 02.
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  8. Jonathan Chiu, 2005. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," 2005 Meeting Papers 108, Society for Economic Dynamics.
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  10. Miguel Molico, 2006. "The Distribution Of Money And Prices In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(3), pages 701-722, 08.
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  12. Rocheteau, Guillaume & Rupert, Peter & Shell, Karl & Wright, Randall, 2005. "General Equilibrium with Nonconvexities, Sunspots, and Money," Working Papers 05-16, Cornell University, Center for Analytic Economics.
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  14. Imrohoroglu, Ayse, 1992. "The welfare cost of inflation under imperfect insurance," Journal of Economic Dynamics and Control, Elsevier, vol. 16(1), pages 79-91, January.
  15. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2003. "On the Sluggish Response of Prices to Money in an Inventory-Theoretic Model of Money Demand," NBER Working Papers 10016, National Bureau of Economic Research, Inc.
  16. Rogerson, Richard, 1988. "Indivisible labor, lotteries and equilibrium," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 3-16, January.
  17. David K. Levine, 1991. "Asset Trading Mechanisms and Expansionary Policy," Levine's Working Paper Archive 43, David K. Levine.
  18. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
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