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Inflation and Welfare: A Search Approach

Authors


  • We have benefited from the comments of an anonymous referee, Ray Batina, Charles Carlstrom, Richard Dutu, Sebastien Lotz, Ed Nosal, Randall Wright, and Christopher Waller as well as seminar participants at the universities of Akron and Paris 2 (Pantheon-Assas), at the Singapore Management University, at the Banque de France, and at the Federal Reserve Banks of Cleveland and Richmond. We thank Patrick Higgins for his research assistance and Monica Crabtree-Reusser and Michele Lachman for editorial assistance. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Abstract

This paper uses a search model of monetary exchange to provide new insights for evaluating the welfare costs of inflation. We first show that the search model of money can rationalize the estimates of the welfare cost of inflation based on the “welfare triangle” methodology of Bailey (1956) and Lucas (2000) provided that buyers appropriate the social marginal benefit of their real balances. For other mechanisms, the measure given by the welfare triangle has to be scaled up by a factor that increases with sellers' market power. We introduce capital and endogenous participation decisions and study how the cost of inflation is affected. We provide calibrated examples in which a deviation from the Friedman rule is optimal.

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