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Liquidity and welfare in a heterogeneous-agent economy

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  • Yi Wen

Abstract

This paper reconsiders the welfare costs of inflation and the welfare gains from financial intermediation in a heterogeneous-agent economy where money is held as a store of value (as in Bewley, 1980). The dynamic stochastic general equilibrium model recaptures some essential features of the liquidity-preference theory of Keynes (1930, 1936). Because of heterogeneous liquidity demand, transitory lump-sum money injections can have persistent expansionary effects despite flexible prices, and such effects can be greatly amplified by the banking system through the credit channel. However, permanent money growth can be extremely costly: With log utility functions, consumers are willing to reduce consumption by 15% (or more) to avoid a 10% annual inflation. For the same reason, financial intermediation can significantly improve welfare: The welfare costs of a collapse of the banking system is estimated as about 10-68% of aggregate output. These welfare implications differ dramatically from those of the existing literature.

Suggested Citation

  • Yi Wen, 2009. "Liquidity and welfare in a heterogeneous-agent economy," Working Papers 2009-019, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2009-019
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    Cited by:

    1. Wen, Yi, 2015. "Money, liquidity and welfare," European Economic Review, Elsevier, vol. 76(C), pages 1-24.

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    Keywords

    Liquidity (Economics);

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