WELFARE COST OF INFLATION IN A GENERAL EQUILIBRIUM MODEL WITH CURRENCY AND INTEREST-BEARING DEPOSITS

Barry Edward Jones (), Gabriel Asaftei and Lian Wang

Macroeconomic Dynamics, 2004, vol. 8, issue 04, pages 493-517

Abstract: We generalize a money-in-the-utility function model to include interest-bearing deposits and use the model to estimate the welfare cost of inflation. In the model, the user cost of deposits is invariant to inflation in steady state. Currency and deposits are assumed to be weakly separable and the model is calibrated using index number methods. We find that the welfare cost of inflation is substantially lower in the model with interest-bearing deposits than in models where all monetary assets are assumed to be non-interest bearing. We also show that higher inflation can raise or lower the rate of convergence to steady state depending on the coefficient of relative risk aversion, but the effect is weak. We provide evidence for OECD countries suggesting that there could be a positive effect of inflation on user costs, which would lead to higher welfare cost estimates.

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