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Liquidity, Redistribution, and the Welfare Cost of Inflation

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  • Jonathan Chiu
  • Miguel Molico

Abstract

This paper studies the long run welfare costs of inflation in a micro-founded model with trading frictions and costly liquidity management. Agents face uninsurable idiosyncratic uncertainty regarding trading opportunities in a decentralized goods market and must pay a fixed cost to rebalance their liquidity holdings in a centralized liquidity market. By endogenizing the participation decision in the liquidity market, this model endogenizes the responses of velocity, output, the degree of market segmentation, as well as the distribution of money. We find that, compared to the traditional estimates based on a representative agent model, the welfare costs of inflation are significantly smaller due to distributional effects of inflation. The welfare cost of increasing inflation from 0% to 10% is 0.62% of income for the U.S. economy and 0.20% of income for the Canadian economy. Furthermore, the welfare cost is generally non-linear in the rate of inflation, depending on the endogenous responses of the liquidity market participation to inflation and liquidity management costs.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 07-39.

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Length: 37 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:bca:bocawp:07-39

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Keywords: Inflation: costs and benefits;

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References

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  1. Huberto M. Ennis, 2009. "Avoiding The Inflation Tax," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(2), pages 607-625, 05.
  2. Stephen Williamson, 2004. "Search, Limited Participation, and Monetary Policy," 2004 Meeting Papers 214, Society for Economic Dynamics.
  3. Dotsey, Michael & Ireland, Peter, 1996. "The welfare cost of inflation in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 37(1), pages 29-47, February.
  4. Jonathan Chiu, 2007. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," Working Papers 07-46, Bank of Canada.
  5. Aleksander Berentsen & Gabriele Camera & Christopher Waller, . "The Distribution of Money Balances and the Non-Neutrality of Money," IEW - Working Papers 220, Institute for Empirical Research in Economics - University of Zurich.
  6. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
  7. Deviatov Alexei & Wallace Neil, 2001. "Another Example in which Lump-sum Money Creation is Beneficial," The B.E. Journal of Macroeconomics, De Gruyter, vol. 1(1), pages 1-22, February.
  8. 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.
  9. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2002. "Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 73-112, February.
  10. Julia Thomas & Aubhik Khan, 2012. "Inflation and Interest Rates with Endogenous Market Segmentation," 2012 Meeting Papers 1070, Society for Economic Dynamics.
  11. David K. Levine, 1991. "Asset Trading Mechanisms and Expansionary Policy," Levine's Working Paper Archive 43, David K. Levine.
  12. Fernando E. Alvarez & Francesco Lippi, 2007. "Financial Innovation and the Transactions Demand for Cash," NBER Working Papers 13416, National Bureau of Economic Research, Inc.
  13. Ben Craig & Guillaume Rocheteau, 2006. "Inflation and welfare: a search approach," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Jan.
  14. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  15. Jovanovic, Boyan, 1982. "Inflation and Welfare in the Steady State," Journal of Political Economy, University of Chicago Press, vol. 90(3), pages 561-77, June.
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