On inflation, wealth inequality and welfare in emerging economies

Evidence shows that globally observed disinflation in the last two decades has been more predominant in emerging economies. This paper undertakes a quantitative investigation of the distributional and welfare consequences of a sharp reduction in inflation in a monetary model of a small open economy with uninsured idiosyncratic earnings risk. Consumers hold non-interest bearing real balances (demand deposits) that economize transactions costs of consumption and internationally-traded risk-free bonds (term deposits) that are useful for consumption smoothing. Bonds are modeled as inflation-indexed to incorporate financial dollarization. Analytical results for deterministic economies show that alternative fiscal responses to inflationary finance create various redistributive wealth effects in addition to wealth-eroding and consumption-distorting effects of inflation. The stochastic model is calibrated to Turkish data and is used to compare stationary equilibria with quarterly inflation rates of 15% (for 1987:1-2003:4) and 2% (for 2004:1-2009:4) under alternative fiscal arrangements. I find that (i) when uniform transfers are endogenous, reducing inflation lowers aggregate welfare by 2.65% in terms of compensating consumption variation. This is because the reduction in the costs of inflation for the poor is less than the decrease in transfers. This also tightens natural debt limits, increases precautionary savings motive and causes the distribution of bonds to be more equitable. When endogenous transfers are proportional to individual-specific inflation tax payments, aggregate welfare increases by 0.5%. This is because proportional transfers do not drive redistributive effects. Welfare gains increase further (1.67%) if wasteful spending is endogenous. The model also generates a cross sectional portfolio consistent with the disaggregated deposits data and the literature.