Infl ation and Welfare : A Search Approach

Views stated in Policy Discussion Papers are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted, provided that the source is credited. Please send copies of reprinted materials to the editor. thank Patrick Higgins for his research assistance and Monica Crabtree-Reusser for editorial assistance. This paper extends recent fi ndings in the search-theoretic literature on monetary exchange regarding the welfare costs of infl ation. We present fi rst some estimates of the welfare cost of infl ation using the " welfare triangle " methodology of Bailey (1956) and Lucas (2000). We then derive a money demand function from the search-theoretic model of Lagos and Wright (2005) and we estimate it from U.S. data over the period 1900–2000. We show that the welfare cost of infl ation predicted by the model accords with the welfare-triangle measure when pricing mechanisms are such that buyers appropriate the social marginal benefi t of their real balances. For other mechanisms, welfare triangles underestimate the true welfare cost of infl ation because of a rent-sharing externality. We also point out other ineffi ciencies associated with noncompetitive pricing, which matter for estimating the cost of infl ation. We then illustrate how endogenous participation decisions can mitigate or exacerbate the cost of infl ation, and we provide calibrated examples in which a deviation from the Friedman rule is optimal. Finally, we discuss distributional effects of infl ation. obtained estimates for the cost of 10 percent infl ation ranging from 0.3 percent of GDP to 0.45 percent of GDP.