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Inflation and welfare: a search approach

  • Ben Craig
  • Guillaume Rocheteau

This paper extends recent findings in the search-theoretic literature on monetary exchange regarding the welfare costs of inflation. We present first estimates of the welfare cost of inflation using the "welfare triangle" methodology of Bailey (1958) and Lucas (2000). We then derive a money demand function from the search-theoretic model of Lagos and Wright (2005) and we estimate it from U.S. data over the period 1900-2000. We show that the welfare cost of inflation predicted by the model accords with the welfare-triangle measure when pricing mechanisms are such that buyers appropriate the social marginal benefit of their real balances. For other mechanisms, welfare triangles underestimate the true welfare cost of inflation because of a rent-sharing externality. We also point out other inefficiencies associated with noncompetitive pricing, which matter for estimating the cost of inflation. We then illustrate how endogenous participation decisions can mitigate or exacerbate the cost of inflation, and we provide calibrated examples in which a deviation from the Friedman rule is optimal. Finally, we discuss distributional effects of inflation.

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Article provided by Federal Reserve Bank of Cleveland in its journal Policy Discussion Papers.

Volume (Year): (2006)
Issue (Month): Jan ()
Pages:

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Handle: RePEc:fip:fedcpd:y:2006:i:jan:n:12
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  1. 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.
  2. Nobuhiro Kiyotaki & Randall Wright, 1989. "A contribution to the pure theory of money," Staff Report 123, Federal Reserve Bank of Minneapolis.
  3. Boragan Aruoba, S. & Rocheteau, Guillaume & Waller, Christopher, 2007. "Bargaining and the value of money," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2636-2655, November.
  4. Kiyotaki, Nobuhiro & Wright, Randall, 1989. "On Money as a Medium of Exchange," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 927-54, August.
  5. 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.
  6. Miquel Faig, 2004. "Divisible Money in an Economy with Villages," Econometric Society 2004 North American Summer Meetings 248, Econometric Society.
  7. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  8. S. Rao Aiyagari & R. Anton Braun & Zvi Eckstein, 1998. "Transaction Services, Inflation, and Welfare," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1274-1301, December.
  9. Nash, John, 1950. "The Bargaining Problem," Econometrica, Econometric Society, vol. 18(2), pages 155-162, April.
  10. Narayana R. Kocherlakota, 2005. "Optimal monetary policy: what we know and what we don’t know," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Oct, pages 10-19.
  11. S. Boragan Aruoba & Randall Wright, 2003. "Search, money, and capital: a neoclassical dichotomy," Proceedings, Federal Reserve Bank of Cleveland, pages 1085-1117.
  12. Li, Victor E, 1995. "The Optimal Taxation of Fiat Money in Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(4), pages 927-42, November.
  13. Guillaume Rocheteau & Randall Wright, 2004. "Money in search equilibrium, in competitive equilibrium, and in competitive search equilibrium," Working Paper 0405, Federal Reserve Bank of Cleveland.
  14. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," Papers 88-05, Rochester, Business - General.
  15. 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.
  16. Reed, Robert R. & Waller, Christopher J., 2006. "Money and Risk Sharing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1599-1618, September.
  17. Lucas, Robert E., 1981. "Discussion of : Stanley Fischer, "towards an understanding of the costs of inflation: II"," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 43-52, January.
  18. Craig, Ben & Rocheteau, Guillaume, 2008. "State-dependent pricing, inflation, and welfare in search economies," European Economic Review, Elsevier, vol. 52(3), pages 441-468, April.
  19. Craig, Ben & Waller, C.J.Christopher J., 2004. "Dollarization and currency exchange," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 671-689, May.
  20. Ennis, Huberto M., 2008. "Search, money, and inflation under private information," Journal of Economic Theory, Elsevier, vol. 138(1), pages 101-131, January.
  21. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  22. Fischer, Stanley, 1981. "Towards an understanding of the costs of inflation: II," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 5-41, January.
  23. Guillaume Rocheteau & Randall Wright, 2003. "Inflation and Welfare in Models with Trading Frictions," PIER Working Paper Archive 03-032, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  24. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  25. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, 2004. "Friedman meets Hosios: efficiency in search models of money," Working Paper 0408, Federal Reserve Bank of Cleveland.
  26. Thomas F. Cooley & Gary D. Hansen, 1991. "The welfare costs of moderate inflations," Proceedings, Federal Reserve Bank of Cleveland, pages 483-518.
  27. Li, Victor E, 1997. "The Efficiency of Monetary Exchange in Search Equilibrium," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 61-72, February.
  28. 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.
  29. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March.
  30. S. Boragan Aruoba & Christopher J. Waller, 2005. "Money and Capital," 2005 Meeting Papers 550, Society for Economic Dynamics.
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