The Welfare Costs of Expected and Unexpected Inflation

The monetary search model by Lagos and Wright (2005) is extended with imperfect information about nominal shocks à la Lucas (1972 and 1973). This framework is useful to estimate the welfare costs of expected and erratic inflation because it provides an avenue to identify the transactions affected by monetary shocks and how tolerant individuals are to the fluctuations of output in these transactions. We find that the welfare gain of eliminating the United States monetary business cycle observed from 1892 to 2005 is 0.01 percent of GDP while the welfare gain of reducing the observed average rate of inflation to the Friedman rule is 0.26 per cent of GDP, that is almost two orders of magnitude higher. We are thankful to the participants of the Cleveland Feb Summer Workshop 2006 for their comments and encouragement. We are also grateful for the financial support of SSHRC of Canada. The usual disclaimer applies. ∗ Department of Economics, University of Toronto, 150 St. George Street, Toronto, Canada, M5S 3G7. E-mail: [email protected] and [email protected].