A Time-Varying Approach of the US Welfare Cost of Inflation

Money demand specifications exhibits instability, especially for long spans of data. This paper reconsiders the welfare cost of inflation for the US economy using a flexible time-varying cointegration methodology to estimate the money demand function. We find evidence that the time-varying cointegration estimation provides a better fit of the actual data than a time-invariant estimation and that the throughout unitary income elasticity only exists for the log-log form over the entire sample period. Our estimate of the welfare cost of inflation for a 10-percent inflation rate lies in the range of 0.025 to 0.75 percent of GDP and averages 0.27 percent. When we plug in the actual inflation rate series over the sample period, we find that the welfare cost of inflation lies in the range of 0.009 to 0.33 percent of GDP. In sum, our findings fall well within the ranges of existing studies of the welfare cost of inflation. Finally, the interest elasticity of money demand shows substantial variability over our sample period.