Inflation, Output, and Welfare in the Laboratory

Abstract

We develop an experimental framework to investigate the quantity theory of money and the real effects of inflation in an economy where money serves as a medium of exchange. We test the classical view that inflation reduces output and welfare by taxing monetary exchange. Inflation is engineered by constant money growth where newly-issued money is injected in one of three ways: to finance government spending, lump-sum transfers, or proportional transfers. Experimental results largely support theoretical predictions. Higher money growth leads to higher inflation. Output and welfare are significantly lower with government spending, output is significantly lower with lump-sum transfers, while there are no significant real effects with proportional transfers. A deviation from theory is that the detrimental effect of money growth depends on the implementation scheme and is stronger with government spending relative to lump-sum transfers.