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Reconsidering the Welfare Cost of Inflation in the US: A Nonparametric Estimation of the Nonlinear Long-Run Money Demand Equation using Projection Pursuit Regressions

Author

Listed:
  • Rangan Gupta

    () (Department of Economics, University of Pretoria)

  • Anandamayee Majumdar

    () (School of Mathematical & Statistical Sciences, Arizona State University)

Abstract

This paper, first, estimates the appropriate, log-log or semi-log, linear long-run money demand relationship capturing the behavior US money demand over the period of 1980:Q1 to 2010:Q4, using the standard linear cointegration procedures found in the literature, and the corresponding nonparametric version of the same based on Projection Pursuit Regression (PPR) methods. We then, compare the resulting welfare costs of inflation obtained from the linear and nonlinear money demand cointegrating equations. We make the following observations: (i) The appropriate money demand relationship for the period of 1980:Q1 to 2010:Q4 is captured by a semi-log function, since no cointegrating relationship could be obtained for the log-log model; (ii) The semi-elasticity of interest rate obtained from the PPR method is found to be more than double the corresponding estimate obtained under the linear case; (iii) Based on the estimation of semi-log cointegrating equations, the welfare cost of inflation was found to at the most lie between 0.0131 percent of GDP to 0.2186 percent of GDP for inflation rates between 0 percent and 10 percent, and; (iv) In comparison, the welfare cost of inflation obtained from the semi-log non-linear long-run money demand function, obtained using the PPR method, for 0 to 10 percent of inflation ranges between 0.4929 to 1.9468 percent of GDP. These results suggest that the Federal Reserve’s current policy, which generates low but still positive rates of inflation, might not be an adequate approximation in terms of the welfare cost of inflation. Perhaps, moving all the way to a Friedman-type deflationary rule for a zero nominal interest is a more desired policy given the size of welfare loss.

Suggested Citation

  • Rangan Gupta & Anandamayee Majumdar, 2011. "Reconsidering the Welfare Cost of Inflation in the US: A Nonparametric Estimation of the Nonlinear Long-Run Money Demand Equation using Projection Pursuit Regressions," Working Papers 201114, University of Pretoria, Department of Economics.
  • Handle: RePEc:pre:wpaper:201114
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    References listed on IDEAS

    as
    1. Peter N. Ireland, 2009. "On the Welfare Cost of Inflation and the Recent Behavior of Money Demand," American Economic Review, American Economic Association, vol. 99(3), pages 1040-1052, June.
    2. Allan H. Meltzer, 1963. "The Demand for Money: The Evidence from the Time Series," Journal of Political Economy, University of Chicago Press, vol. 71, pages 219-219.
    3. repec:bla:restud:v:57:y:1990:i:1:p:99-125 is not listed on IDEAS
    4. Hansen, Bruce E., 1992. "Efficient estimation and testing of cointegrating vectors in the presence of deterministic trends," Journal of Econometrics, Elsevier, vol. 53(1-3), pages 87-121.
    5. Stock, James H & Watson, Mark W, 1993. "A Simple Estimator of Cointegrating Vectors in Higher Order Integrated Systems," Econometrica, Econometric Society, vol. 61(4), pages 783-820, July.
    6. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
    7. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
    8. 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.
    9. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-1580, November.
    10. Phillips, Peter C B & Ouliaris, S, 1990. "Asymptotic Properties of Residual Based Tests for Cointegration," Econometrica, Econometric Society, vol. 58(1), pages 165-193, January.
    11. Barry Z. Cynamon & Donald H. Dutkowsky & Barry E. Jones, 2006. "Redefining the Monetary Agggregates: A Clean Sweep," Eastern Economic Journal, Eastern Economic Association, vol. 32(4), pages 661-672, Fall.
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    Cited by:

    1. Stephen M. Miller & Luis F. Martins & Rangan Gupta, 2014. "A Time-Varying Approach of the US Welfare Cost of Inflation," Working Papers 201419, University of Pretoria, Department of Economics.
    2. repec:ipg:wpaper:2014-474 is not listed on IDEAS
    3. Helmut Herwartz & Jordi Sardà & Bernd Theilen, 2016. "Money demand and the shadow economy: empirical evidence from OECD countries," Empirical Economics, Springer, vol. 50(4), pages 1627-1645, June.

    More about this item

    Keywords

    Cointegration; Money Demand; Projection Pursuit Regression; Welfare Cost of Inflation;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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