The Distortionary Effects of Inflation: An Empirical Investigation

In a wide class of monetary models with both cash and credit goods, the main welfare cost of inflation is that it distorts the choice between these two goods. In these models, distortions exist because the relevant measure of the relative price between cash and credit goods for consumers is the usual relative price discounted by the nominal interest rate. Changes in the inflation rate therefore create distortions by affecting the nominal interest rate. This paper proposes a new statistical method for detecting the existence and magnitude of this distortion in a monetary model of the consumption-leisure choice. The empirical analysis is motivated by deriving a long-run restriction between the stochastic and deterministic trends of real consumption, the real wage rate and the gross nominal interest rate from the first-order conditions of the representative agent's optimization problem. Using nondurableand foodconsumption as cash goods, and leisure as the credit good, this method is applied to a diverse group of 12 economies. The evidence suggests that such distortions exist and tend to be statistically and economically significant for most highand medium-inflation economies, but not for low-inflation economies. JEL Classification: E21 (Consumption), E41 (Demand for Money), C22 (Single-Equation Time-Series Models)