In macroeconomics, the welfare cost of inflation comprises the changes in social welfare caused by inflation.
The traditional approach, developed by Bailey (1956) and Friedman (1969), treats real money balances as a consumption good and inflation as a tax on real balances. This approach measures the welfare cost by computing the appropriate area under the money demand curve. Fischer (1981) and Lucas (1981), find the cost of inflation to be low. Fischer computes the deadweight loss generated by an increase in inflation from zero to 10 percent as just 0.3 percent of GDP using the monetary base as the definition of money. Lucas places the cost of a 10 percent inflation at 0.45 percent of GDP using M1 as the measure of money. Lucas (2000) revised his estimate upward, to slightly less than 1 percent of GDP. Ireland (2009) extends this line of analysis to study the recent behavior of U.S. money demand.
Structural models are a recent alternative to econometric estimates of the triangle under an estimated money demand curve. Cooley and Hansen (1989) calibrate a cash-in-advance version of a business cycle model. They find that the welfare cost of 10 per cent inflation is about 0.4 per cent of GNP. Among recent general-equilibrium models that estimate the welfare cost of inflation are Dotsey and Ireland (1996), Aiyagari, Braun, and Eckstein (1998), Burstein and Hellwig (2008), and Henriksen and Kydland (2010).
Craig and Rocheteau (2008) argue that a search-theoretic framework is necessary for appropriately measuring the welfare cost of inflation. Lagos and Wright (2005) model monetary exchange and provide estimates for the annual cost of 10 percent inflation to be between 3 and 4 percent of GDP.
- Aiyagari, S. Rao; Braun, R. Anton; Eckstein, Zvi (1998). “Transaction Services, Inflation, and Welfare” (PDF). Journal of Political Economy. 106(6): 1274. doi:10.1086/250047.
- Bailey, Martin (1956). “The Welfare Cost of Inflationary Finance”. Journal of Political Economy. 64(2): 93–110. doi:10.1086/257766.
- Burstein, Ariel; Hellwig, Christian (2008). “Welfare costs of inflation in a menu cost model”. American Economic Review. 98(2): 438–43. CiteSeerX 10.1.1.309.2745. doi:10.1257/aer.98.2.438.
- Cooley, Thomas F.; Hansen, Gary (1989). “The Inflation Tax in a Real Business Cycle”. American Economic Review. 79(4): 733–44.
- Craig, Ben; Rocheteau, Guillaume (2008). “Inflation and Welfare: A Search Approach” (PDF). Journal of Money, Credit and Banking. 40(1): 89–119. doi:10.1111/j.1538-4616.2008.00105.x.
- Dotsey, Michael; Ireland, Peter N. (1996). “The Welfare Cost of Inflation in General Equilibrium” (PDF). Journal of Monetary Economics. 37(1): 29–47. doi:10.1016/0304-3932(95)01239-7.
- Fischer, Stanley (1981), “Towards an Understanding of the Costs of Inflation: II”, Carnegie-Rochester Conference Series on Public Policy, 15: 5–41, doi:10.1016/0167-2231(81)90016-6
- Friedman, Milton (1969). The Optimum Quantity of Money and Other Essays. Chicago: Aldine Publishing Company.
- Henriksen, Espen; Kydland, Finn (2010). “Endogenous Money, Inflation and Welfare”. Review of Economic Dynamics. 13(2): 470–86. doi:10.1016/j.red.2009.09.003.
- Ireland, Peter N. (2009). “On the Welfare Cost of Inflation and the Recent Behavior of Money Demand” (PDF). American Economic Review. 99(3): 1040–52. doi:10.1257/aer.99.3.1040.
- Lagos, Ricardo; Wright, Randall (2005). “A Unified Framework for Monetary Theory and Policy Analysis”. Journal of Political Economy. 113(3): 463–84. CiteSeerX 10.1.1.563.3199. doi:10.1086/429804.
- Lucas, Robert E., Jr. (1981). “Discussion of: Stanley Fischer, ‘Towards an Understanding of the Costs of Inflation II.'”. Carnegie-Rochester Conference Series on Public Policy. 15: 43–52. doi:10.1016/0167-2231(81)90017-8.
- Lucas, Robert E., Jr. (2000). “Inflation and Welfare”. Econometrica. 68(2): 247–274. doi:10.1111/1468-0262.00109.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.