Monopolistic Competition, Increasing Returns to Scale, and the Welfare Costs of Inflation

Abstract:     
This paper introduces monopolistic competition and increasing returns to scale into a monetary real business cycle (RBC) model to re-estimate the welfare costs of inflation. We first calibrate the model and show that it is capable of generating the observed aggregate fluctuations even when there are no shocks to the fundamentals. In particular, we demonstrate that this model matches the stylized U.S. business cycles facts as well as two more standard models. Then, we find that in this model the scale parameters and the intensity of competition significantly affect the welfare cost of inflation. Specifically, the cost is considerably higher than that in a standard RBC model with competitive markets and constant returns. Moreover, the stronger the increasing returns and the less intense the competition, the higher the welfare cost. These results are confirmed in a number of model specifications.

JEL Classifications: E31, E32, E37

Working Paper Series