Inflation and Welfare: A Search Approach

43 Pages Posted: 28 Oct 2007 Last revised: 5 Feb 2024

See all articles by Ben R. Craig

Ben R. Craig

Federal Reserve Bank of Cleveland; Deutsche Bundesbank

Guillaume Rocheteau

Federal Reserve Bank of Cleveland; National University of Singapore (NUS)

Date Written: May 24, 2006

Abstract

This paper extends recent findings in the search-theoretic literature on monetary exchange regarding the welfare costs of inflation. We present first estimates of the welfare cost of inflation using the welfare triangle methodology of Bailey (1958) and Lucas (2000). We then derive a money demand function from the search-theoretic model of Lagos and Wright (2005) and we estimate it from U.S. data over the period 1900-2000. We show that the welfare cost of inflation predicted by the model accords with the welfare-triangle measure when pricing mechanisms are such that buyers appropriate the social marginal benefit of their real balances. For other mechanisms, welfare triangles underestimate the true welfare cost of inflation because of a rent-sharing externality. We also point out other inefficiencies associated with noncompetitive pricing, which matter for estimating the cost of inflation. We then illustrate how endogenous participation decisions can mitigate or exacerbate the cost of inflaion, and we provide calibrated examples in which a deviation from the Friedman rule is optimal. Finally, we discuss distributional effects of inflation.

Keywords: inflation, search, money

JEL Classification: E40, E50

Suggested Citation

Craig, Ben R. and Rocheteau, Guillaume, Inflation and Welfare: A Search Approach (May 24, 2006). FRB of Cleveland Policy Discussion Paper No. 12, Available at SSRN: https://ssrn.com/abstract=1024838

Ben R. Craig (Contact Author)

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Guillaume Rocheteau

Federal Reserve Bank of Cleveland ( email )

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