The Welfare Effects of Inflation Volatility and Institutions

Using a micro-foundation based monetary Small Open Economy (SOE) model of McCandless (2008) with a cash-in-advance constraint, a capital adjustment cost, foreign bonds, and a trade sector, the study quantifies the welfare implications under two policy scenarios: ( a ) a reduction in inflation volatility and ( b ) an improvement in institutions. The monetary small open economy model is calibrated using quarterly data from 1989 to 2006 for an emerging market economy, Mexico, a country that, by the study’s measure has poor financial institutions and moderately high inflation volatility. The results of the model suggest that decreasing inflation volatility leads to about 8 percent increase in welfare, at most, while improving institutions leads to an increase in welfare by about 10 percent, at most. Furthermore, when the decrease in inflation volatility is coupled with the improvement in institutions the welfare increase is in the range of around 11–19 percent, depending on the degree of the drop in inflation volatility and the level of development in financial institutions. Finally, the study analyzes the impact of the reduction in inflation volatility versus the impact of the improvement in institutions on the behavior of the endogenous variables along the transition path. One policy implication of these results is that an emerging market economy, like Mexico, with relatively high inflation volatility and underdeveloped financial institutions, can get large welfare gains from either reducing inflation volatility or improving their institutions, with the largest gains coming from the latter. A long-run sustainable economic development policy will lean more towards the improvement in institutions rather than the reduction of inflation volatility.