On the Welfare Cost of Inflation in a New Keynesian Model with a Cash-in-advance Constraint: The Case of Iran

Abstract

T he welfare cost of inflation in a new Keynesian model has been studied in this article. Nominal prices and wages are subjected to Rotenberg's adjustments in the benchmark model. In addition, this study uses the CIA model to compare the welfare cost of seigniorage tax and consumption tax. The model is calibrated for the Iranian economy and the results of the calibration are as following: In a steady state, a seigniorage tax imposes higher costs on social welfare rather than consumption taxes. We also find that the welfare cost of inflation increases linearly with the inflation rate and the welfare cost in a model without the government is higher than the model with government expenditures. Numerically, in the benchmark model, an annual inflation rate of 10% entails a welfare cost (relative to a -1.5% annual inflation rate, the Friedman Rule’s level of inflation rate) of 1.69% of a steady state consumption without a government. If we add the government to the model, this cost will be 1.28%. This amount will be only 0.5% if we use the RBC model. According to Ascra's measurement (2009), inflation tax increases welfare costs, but consumption tax decreases welfare costs.