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Monetary exchange and the irreducible cost of inflation

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  • Wong, Tsz-Nga

Abstract

This paper applies a mechanism design approach to construct a lower bound to the welfare cost of inflation that does not depend on quasi-linear preferences or details of how agents trade. An incentive-feasible trading protocol is derived to minimize the welfare loss subject to frictions rendering money essential. The welfare cost of inflation under this optimal protocol is the lower bound over all pairwise trading protocols of monetary exchange. In general, the first-best is not implementable, even under the Friedman's rule, patient agents and the optimal mechanism. Thus, the lower bound depends on fundamentals like preferences and technology. Finally, I estimate the irreducible cost of 10% inflation with the U.S. data from 1900 to 2000.

Suggested Citation

  • Wong, Tsz-Nga, 2016. "Monetary exchange and the irreducible cost of inflation," Journal of Economic Theory, Elsevier, vol. 164(C), pages 218-229.
    • Handle: RePEc:eee:jetheo:v:164:y:2016:i:c:p:218-229
    DOI: 10.1016/j.jet.2016.02.008
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    References listed on IDEAS

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    1. Tai-wei Hu & John Kennan & Neil Wallace, 2009. "Coalition-Proof Trade and the Friedman Rule in the Lagos-Wright Model," Journal of Political Economy, University of Chicago Press, vol. 117(1), pages 116-137, February.
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    4. Robert E. Lucas, 2001. "Inflation and Welfare," International Economic Association Series, in: Axel Leijonhufvud (ed.), Monetary Theory as a Basis for Monetary Policy, chapter 4, pages 96-142, Palgrave Macmillan.
    5. Rocheteau, Guillaume, 2012. "The cost of inflation: A mechanism design approach," Journal of Economic Theory, Elsevier, vol. 147(3), pages 1261-1279.
    6. Tsz-Nga Wong, 2016. "A Tractable Monetary Model under General Preferences," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 83(1), pages 402-420.
    7. Rocheteau, Guillaume & Weill, Pierre-Olivier & Wong, Russell, 2018. "A tractable model of monetary exchange with ex-post heterogeneity," Theoretical Economics, Econometric Society, vol. 13(3), September.
    8. Chiu, Jonathan & Molico, Miguel, 2010. "Liquidity, redistribution, and the welfare cost of inflation," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 428-438, May.
    9. Jonathan Chiu & Tsz-Nga Wong, 2015. "On the Essentiality of E-Money," Staff Working Papers 15-43, Bank of Canada.
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    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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