Inflation and Welfare in the Laboratory

We integrate theory and experimental evidence to study the effects of alternative inflationary monetary policies on allocations and welfare. The framework of our experiment is based on the Lagos and Wright (2005) model of monetary exchange that provides a role for money as a medium of exchange. We compare a baseline laissez-faire policy with constant money growth and three different inflationary policies where the government fixes the money growth rate. In the first scheme (Government Spending), the government adjusts expenditures financed through seigniorage; in the second scheme (Lump Sum Transfers), the government injects new money through lump-sum transfers; in the third scheme (Proportional Transfers), the government makes transfers proportional to individual money holdings. Theory predicts inflation is constant at the money growth rate in a stationary equilibrium under all inflationary policies. However, while the first two policies yield the same stationary equilibrium with lower welfare relative to the laissez-faire setting, the third policy is neutral. Consistent with theory, output and welfare in the experimental economies are significantly lower with Government Spending relative to baseline while there are no significant effects with Proportional transfers. Our findings have implications on monetary policy implementation and provide support for policies in line with the quantity theory.