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Inflation taxes, financial intermediation, and home production

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Milton H. Marquis

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Abstract

This paper examines the incidence and welfare costs of inflation in the presence of financial market frictions and home production. The results suggest that financing constraints on firms' working capital expenditures significantly increase the welfare costs relative to the standard Cooley-Hansen (1989) cash-in-advance framework. These costs are reduced, but remain above those computed by Cooley and Hansen, when a financial intermediary is introduced that engages in asset transformation by creating liquid, interest-bearing deposit accounts and uses the proceeds to finance working capital loans to firms. Explicitly modeling home production activities tends to exacerbate the distortions that inflation induces in employment and market output to a considerable degree, and suggests that welfare costs of anticipated inflation may be substantially higher than previous estimates. Sensitivity analysis indicates that the magnitude of the market response to inflation and the attendant welfare costs of inflation depend strongly on the elasticity of substitution between capital and labor in home production, and to a much lesser degree on the elasticity of substitution between home and market consumption. When households must also finance their gross investment in home capital by borrowing from the financial intermediary, home production is indirectly taxed by inflation. As a result of this credit friction, resources thus tend to move back into the market, thereby mitigating the adverse effects of inflation on employment and output, while further increasing the welfare losses.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 2001-04.

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Date of creation: 2001
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Handle: RePEc:fip:fedfap:2001-04

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Keywords: Inflation (Finance) Consumer behavior

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  1. Paul Gomme, 1991. "Money and growth revisited," Discussion Paper / Institute for Empirical Macroeconomics 55, Federal Reserve Bank of Minneapolis. [Downloadable!]
  2. Cooley, Thomas F & Hansen, Gary D, 1989. "The Inflation Tax in a Real Business Cycle Model," American Economic Review, American Economic Association, vol. 79(4), pages 733-48, September. [Downloadable!] (restricted)
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  3. Marquis, Milton H & Reffett, Kevin L, 1992. "Capital in the Payments System," Economica, London School of Economics and Political Science, vol. 59(235), pages 351-64, August. [Downloadable!] (restricted)
  4. Einarsson, Tor & Marquis, Milton H, 1999. "Transitional and Steady-State Costs of Disinflation When Growth Is Endogenous," Economica, London School of Economics and Political Science, vol. 66(264), pages 489-508, November. [Downloadable!] (restricted)
  5. Marquis, Milton H & Reffett, Kevin L, 1995. "The Inflation Tax in a Convex Model of Equilibrium Growth," Economica, London School of Economics and Political Science, vol. 62(245), pages 109-21, February. [Downloadable!] (restricted)
  6. Thomas F. Cooley & Gary D. Hansen, 1991. "The welfare costs of moderate inflations," Proceedings, Federal Reserve Bank of Cleveland, pages 483-518.
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  7. Chang, Wen-ya & Lai, Ching-chong, 2000. "Anticipated Inflation in a Monetary Economy with Endogenous Growth," Economica, London School of Economics and Political Science, vol. 67(267), pages 399-417, August. [Downloadable!] (restricted)
  8. Marquis, Milton-H, 1999. "The Joint and Several Effects of Liquidity Constraints, Financing Constraints, and Financial Intermediation on the Welfare Cost of Inflation," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 17(2), pages 1-20, August. [Downloadable!]
  9. Marquis, Milton H & Reffett, Kevin L, 1994. "New Technology Spillovers into the Payment System," Economic Journal, Royal Economic Society, vol. 104(426), pages 1123-38, September. [Downloadable!] (restricted)
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  10. Greenwood, Jeremy & Hercowitz, Zvi, 1991. "The Allocation of Capital and Time over the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 99(6), pages 1188-214, December. [Downloadable!] (restricted)
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  11. Robert E. Lucas, Jr., 1989. "On the Mechanics of Economic Development," NBER Reprints 1176, National Bureau of Economic Research, Inc.
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  12. McGrattan, Ellen R & Rogerson, Richard & Wright, Randall, 1997. "An Equilibrium Model of the Business Cycle with Household Production and Fiscal Policy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(2), pages 267-90, May.
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  13. De Gregorio, Jose, 1993. "Inflation, taxation, and long-run growth," Journal of Monetary Economics, Elsevier, vol. 31(3), pages 271-298, June. [Downloadable!] (restricted)
  14. Wang, Ping & Yip, Chong K, 1992. "Alternative Approaches to Money and Growth," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(4), pages 553-62, November. [Downloadable!] (restricted)
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