Abstract
This paper develops an analytically tractable Bewley model of money featuring capital and …nancial intermediation. It is shown that when money is a vital form of liquidity to meet uncertain consumption needs, the welfare costs of in‡ation can be extremely large. With log utility and parameter values that best match both the aggregate money demand curve suggested by Lucas (2000) and the variance of household consumption, agents in our model are willing to reduce consumption by 7% � 10% (or more) to avoid 10% annual in‡ation. In other words, raising the U.S. in‡ation target from 2% to 3% amounts to roughly a 0:5 percentage reduction in aggregate consumption. The astonishingly large welfare costs of in‡ation arise because in‡ation
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