Academic journal article Journal of Money, Credit & Banking

Inflation and Welfare: A Search Approach

Academic journal article Journal of Money, Credit & Banking

Inflation and Welfare: A Search Approach

Article excerpt

ASSESSING THE WELFARE costs of inflation requires a sound understanding of the benefits of monetary exchange. The search theory of money, developed in the last 15 years from the pioneering works of Kiyotaki and Wright (1989, 1993), offers such a framework. However, the first generation of search models of money were based on assumptions that were too restrictive to deliver useful insights for monetary policy (goods and money were indivisible; individuals' portfolios were limited to one unit of one object, and so forth). These severe restrictions have been relaxed in several recent extensions of the theory by Shi (1997, 1999), Faig (Forthcoming), Lagos and Wright (2005), and Molico (2006), allowing the search model of money to be integrated with standard neoclassical growth theory (Shi 1998, Aruoba,

Waller, and Wright 2006). This integration with mainstream macroeconomics has opened up the perspectives for a better understanding of the costs--and also maybe benefits--associated with inflationary finance.

As an example, Lagos and Wright (2005) provide estimates for the annual cost of 10% inflation ranging from 1.4% of gross domestic product (GDP) to 4.6% of GDP. These numbers are significantly larger than estimates based on the traditional method developed by Bailey (1956), which consists of computing the area underneath a money demand function. For instance, Lucas (2000), using Bailey's approach, estimates the cost of 10% inflation at slightly less than 1% of GDP. (1)

In this paper, we clarify and extend recent findings regarding the cost of inflation in search environments. Our approach consists of relating the measures of the welfare cost of inflation obtained from a search-theoretic model of monetary exchange--we use the formulation by Lagos and Wright (2005)--to the traditional measures based on the Bailey-Lucas methodology. We show the conditions under which the two measures are consistent and those under which they differ. We also disentangle the various effects of inflation by considering different extensions of the search model: we allow for different pricing mechanisms, participation decisions, and a choice to accumulate capital.

Our first result establishes that the traditional estimates for the welfare cost of inflation provided by the Bailey-Lucas methodology--the area underneath money demand--can be rationalized by a particular version of the search model. If money holders can appropriate the marginal social return of their real balances, the welfare cost of inflation as predicted by the search model is essentially the same as the area underneath the money demand function. This condition is satisfied when buyers have all the bargaining power to set prices in bilateral trades or when pricing is competitive. Any discrepancy between the estimates from the search model and the previous estimates in the literature arises from the use of different strategies to fit money demand.

Our second contribution is to clarify why alternative pricing mechanisms can exacerbate the welfare cost of inflation. We consider a simple rent-sharing rule (the proportional bargaining solution) and we establish a relationship between the cost of inflation, the area underneath the money demand function, and the buyer's market power. If the surplus of a trade is shared evenly between the buyer and the seller in a match, the welfare cost of inflation is twice as large as the estimate provided by the area underneath money demand. When sellers' bargaining power is chosen to be consistent with a realistic markup, the cost of 10% inflation is about 2.5% of GDP. The Bailey-Lucas measure of the cost of inflation is inaccurate because of a rent-sharing externality when buyers do not have all the bargaining power in bilateral matches. We also discuss the ability of the Friedman rule to generate the first best allocation under various pricing mechanisms. Under the generalized Nash solution or under a constant-markup pricing policy, the quantities traded are always inefficiently low (provided that buyers do not have all the bargaining power), which matters when quantifying the benefits of optimal deflation. …

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