Liquidity, redistribution, and the welfare cost of inflation

Abstract

The long-run welfare costs of inflation are studied in a micro-founded model with trading frictions and costly liquidity management. By modelling the liquidity management decision, the model endogenizes the responses of velocity, output, the degree of market segmentation, and the distribution of money. Compared to the traditional estimates based on a representative agent model, the welfare costs of inflation are significantly smaller due to distributional effects of inflation. The welfare cost of increasing inflation from 0% to 10% is 0.62% of consumption for the US economy. Furthermore, the welfare cost is generally non-linear in the inflation rate.