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Liquidity, Redistribution, and the Welfare Cost of Inflation

  • Jonathan Chiu
  • Miguel Molico

This paper studies the long run welfare costs of inflation in a micro-founded model with trading frictions and costly liquidity management. Agents face uninsurable idiosyncratic uncertainty regarding trading opportunities in a decentralized goods market and must pay a fixed cost to rebalance their liquidity holdings in a centralized liquidity market. By endogenizing the participation decision in the liquidity market, this model endogenizes the responses of velocity, output, the degree of market segmentation, as well as the distribution of money. We find that, compared to the traditional estimates based on a representative agent model, the welfare costs of inflation are significantly smaller due to distributional effects of inflation. The welfare cost of increasing inflation from 0% to 10% is 0.62% of income for the U.S. economy and 0.20% of income for the Canadian economy. Furthermore, the welfare cost is generally non-linear in the rate of inflation, depending on the endogenous responses of the liquidity market participation to inflation and liquidity management costs.

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Paper provided by Bank of Canada in its series Working Papers with number 07-39.

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Length: 37 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:bca:bocawp:07-39
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  1. Michael Dotsey & Peter Ireland, 1994. "The welfare cost of inflation in general equilibrium," Working Paper 94-04, Federal Reserve Bank of Richmond.
  2. 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.
  3. Aleksander Berentsen & Gabriele Camera & C hristopher W aller, 2005. "The Distribution Of Money Balances And The Nonneutrality Of Money," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 465-487, 05.
  4. Jonathan Chiu, 2005. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," 2005 Meeting Papers 108, Society for Economic Dynamics.
  5. Alvarez, Fernando & Lippi, Francesco, 2007. "Financial Innovation and the Transactions Demand for Cash," CEPR Discussion Papers 6472, C.E.P.R. Discussion Papers.
  6. Miguel Molico & Jonathan Chiu, 2008. "Monetary Policy, Price Dynamics, and Welfare," 2008 Meeting Papers 749, Society for Economic Dynamics.
  7. 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.
  8. Huberto M. Ennis, 2007. "Avoiding the inflation tax," Working Paper 07-06, Federal Reserve Bank of Richmond.
  9. Jonathan Chiu & Miguel Molico, 2008. "Uncertainty, Inflation, and Welfare," Working Papers 08-13, Bank of Canada.
  10. Jovanovic, Boyan, 1982. "Inflation and Welfare in the Steady State," Journal of Political Economy, University of Chicago Press, vol. 90(3), pages 561-77, June.
  11. Ben Craig & Guillaume Rocheteau, 2006. "Inflation and welfare: a search approach," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Jan.
  12. Stephen D. Williamson, 2006. "Search, Limited Participation, And Monetary Policy ," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(1), pages 107-128, 02.
  13. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  14. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  15. E.S. Andersen, 2007. "Innovation and Demand," Chapters, in: Elgar Companion to Neo-Schumpeterian Economics, chapter 47 Edward Elgar.
  16. David K. Levine, 1991. "Asset Trading Mechanisms and Expansionary Policy," Levine's Working Paper Archive 43, David K. Levine.
  17. Julia Thomas & Aubhik Khan, 2012. "Inflation and Interest Rates with Endogenous Market Segmentation," 2012 Meeting Papers 1070, Society for Economic Dynamics.
  18. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2002. "Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 73-112, February.
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