Liquidity Demand and Welfare in a Heterogeneous-Agent Economy

This paper provides an analytically tractable general-equilibrium model of money demand with micro-foundations. The model is based on the incomplete-market model of Bewley (1980) where money serves as a store of value and provides liquidity to smooth consumption. The model is applied to study the e¤ects of monetary policies. It is shown that heterogeneous liquidity demand can lead to sluggish movements in aggregate prices and positive responses from aggregate output to transitory money injections. However, permanent money growth can be extremely costly: With log utility function and an endogenously determined distribution of money balances that matches the household data, agents are willing to reduce consumption by 8% (or more) to avoid 10% annual in‡ation. The large welfare cost of in‡ation arises because in‡ation destroys the liquidity value and the bu¤er-stock function of money, thus raising the volatility of consumption for low-income households. The astonishingly large welfare cost of moderate in‡ation provides a justi…cation for adopting a low in‡ation target by central banks and o¤ers an explanation for the empirical relationship between in‡ation and social unrest in developing countries. Keywords: Liquidity Preference, Money Demand, Incomplete Markets, Velocity, Welfare Costs of In‡ation. JEL codes: E12, E31, E41, E51. This paper is a signi…cantly revised version of Wen (2009a). I thank Pengfei Wang for discussions on issues related to this project; Costas Azariadis, Jinghui Bai, Aleksander Berentsen, Gabriele Camera, Mark Huggett, Qing Liu, Rodolfo Manuelli, Pengfei Wang, Steve Williamson, and seminar participants at Georgetown University and St. Louis Fed for comments; Judy Ahlers for editorial assistance; and Yu man Tam and Luke Shimek for research assistance. The views expressed do not re‡ect o¢ cial positions of the Federal Reserve Bank of St. Louis and the usual disclaimer applies. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, P.O. Box 422, St. Louis, MO, 63166. Phone: 314-444-8559. Fax: 314-444-8731. Email: [email protected].