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A transitional analysis of the welfare cost of inflation

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  • Clark A. Burdick
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    Abstract

    This paper applies new computational methods for studying nonstationary dynamics to reevaluate the welfare cost of inflation. A dynamic stochastic general equilibrium model with heterogeneous agents is studied. Incomplete markets induce agents to hold a fiat currency as insurance against idiosyncratic income fluctuations. Rather than comparing steady state equilibria, I measure the welfare cost of inflation by explicitly modeling the transitional dynamics that arise following a change in monetary policy. Transitional dynamics are shown to increase the welfare cost of inflation substantially. Also, contrary to conventional wisdom, transitional dynamic effects are shown to increase the benefits of reducing the inflation rate.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 97-15.

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    Date of creation: 1997
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    Handle: RePEc:fip:fedawp:97-15

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    Keywords: Econometric models ; Inflation (Finance) ; Monetary policy ; Money ; Welfare;

    References

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    1. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
    2. repec:fth:simfra:93-03 is not listed on IDEAS
    3. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
    4. Thomas F. Cooley & Gary D. Hansen, 1987. "The Inflation Tax in a Real Business Cycle Model," UCLA Economics Working Papers 496, UCLA Department of Economics.
    5. Timothy J. Kehoe & David K. Levine & Michael Woodford, 1990. "The optimum quantity of money revisited," Working Papers 404, Federal Reserve Bank of Minneapolis.
    6. Gomme, Paul, 1993. "Money and growth revisited : Measuring the costs of inflation in an endogenous growth model," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 51-77, August.
    7. Marty, Alvin L., 1976. "A note on the welfare cost of money creation," Journal of Monetary Economics, Elsevier, vol. 2(1), pages 121-124, January.
    8. James B. Bullard & Steven Russell, 2004. "How costly is sustained low inflation for the U.S. economy?," Review, Federal Reserve Bank of St. Louis, issue May, pages 35-68.
    9. Javier Diaz-Gimenez & Edward C. Prescott & Terry Fitzgerald & Fernando Alvarez, 1992. "Banking in computable general equilibrium economies," Staff Report 153, Federal Reserve Bank of Minneapolis.
    10. Ayse Imrohoroglu & Edward C. Prescott, 1991. "Evaluating the welfare effects of alternative monetary arrangements," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-10.
    11. 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.
    12. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
    13. Scheinkman, Jose A & Weiss, Laurence, 1986. "Borrowing Constraints and Aggregate Economic Activity," Econometrica, Econometric Society, vol. 54(1), pages 23-45, January.
    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. N. Gregory Mankiw, 1994. "Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number greg94-1, July.
    16. Robert E. Lucas, Jr., 1994. "On the welfare cost of inflation," Working Papers in Applied Economic Theory 94-07, Federal Reserve Bank of San Francisco.
    17. Martin S. Feldstein, 1997. "The Costs and Benefits of Going from Low Inflation to Price Stability," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 123-166 National Bureau of Economic Research, Inc.
    18. Bewley, Truman, 1977. "The permanent income hypothesis: A theoretical formulation," Journal of Economic Theory, Elsevier, vol. 16(2), pages 252-292, December.
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    Cited by:
    1. H. Takizawa & E. H. Gardner & Kenichi Ueda, 2004. "Are Developing Countries Better off Spending their Oil Wealth Upfront?," IMF Working Papers 04/141, International Monetary Fund.
    2. Pablo A. Guerron-Quintana, 2010. "The implications of inflation in an estimated New-Keynesian model," Working Papers 10-2, Federal Reserve Bank of Philadelphia.

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