U.S. Money Demand and the Welfare Cost of Inflation in a Currency–Deposit Model

This paper emphasizes that it is crucial to identify the proper specification of money demand as well as the appropriate monetary aggregate to find the exact welfare cost of inflation. The econometric test results obtained from the nonlinear form of money demand with Box–Cox restriction indicate that not the semi-logarithmic form but the double-log form with constant elasticity of less than one is a more accurate characterization of the actual data. The welfare cost estimates for the U.S. economy from Bailey’s (1956) consumer’s surplus and Lucas’s (1994) compensating variation approaches imply that for each monetary model (currency–deposit, single-asset) and each scale variable (income, consumption) the double-log function, compared to the constant semi-elasticity Cagantype demand for money, yields substantial welfare gains in moving from zero inflation to the Friedman optimal deflation rate needed to bring nominal interest rates to zero. This paper also shows that the estimated welfare cost of inflation is proportional to the money stock and because M1 is about three times the monetary base in the United States, identifying M1 without modeling the distinctive roles of currency and deposits as the relevant definition of money overestimates the true welfare cost of inflation. © 2000 Elsevier Science Inc.