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Money, liquidity and welfare

Yi Wen ()

No 2014-3, Working Papers from Federal Reserve Bank of St. Louis

Abstract: This paper develops an analytically tractable Bewley model of money demand to shed light on some important questions in monetary theory, such as the welfare cost of inflation. It is shown that when money is a vital form of liquidity to meet uncertain consumption needs, the welfare costs of inflation 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 3% ~ 4% to avoid 10% annual inflation. The astonishingly large welfare costs of inflation arise because inflation increases consumption risk by eroding the buffer-stock-insurance value of money, thus hindering consumption smoothing at the household level. Such an inflation-induced increase in consumption risk at the micro level cannot be captured by representative-agent models or the Bailey triangle. Although the development of financial intermediation can mitigate the problem, with realistic credit limits the welfare loss of moderate inflation still remains several times larger than estimations based on the Bailey triangle. Our findings provide not only a justification for adopting a low inflation target by central banks, but also a plausible explanation for the robust positive relationship between moderate inflation and social unrest in developing countries where money is the major form of household financial wealth.

Keywords: Liquidity Preference; Money Demand; Financial Intermediation; Velocity; Welfare Costs of Inflation (search for similar items in EconPapers)
JEL-codes: D10 D31 D60 E31 E41 E43 E49 E51 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac, nep-mon and nep-sog
Date: 2014-02-07
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Journal Article: Money, liquidity and welfare (2015) Downloads
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