Liquidity and Welfare in a Heterogeneous-Agent Economy

This paper reconsiders the welfare costs of in‡ation and the welfare gains from …nancial intermediation in a heterogeneous-agent economy where money is held as a store of value (as in Bewley, 1980). Because of heterogeneous liquidity demand, transitory lump-sum money injections can have persistent expansionary e¤ects despite ‡exible prices, and such e¤ects can be greatly ampli…ed by the banking system through the credit channel. However, permanent money growth can be extremely costly: With log utility functions, consumers are willing to reduce consumption by 15% (or more) to avoid a 10% annual in‡ation. For the same reason, …nancial intermediation can signi…cantly improve welfare: The welfare costs of a collapse of the banking system is estimated as about 10 68% of aggregate output. These welfare implications di¤er dramatically from those of the existing literature.