By Alexandre Janiak and Paulo Santos Monteiro

http://d.repec.org/n?u=RePEc:iza:izadps:dp4559&r=dge

We analyze the welfare cost of inflation in a model with cash-in-advance constraints and an endogenous distribution of establishments’ productivities. Inflation distorts aggregate productivity through firm entry dynamics. The model is calibrated to the United States economy and the long-run equilibrium properties are compared at low and high inflation. We find that, when the period over which the cash-in-advance constraint is binding is one quarter, an annual inflation rate of 10 percent leads to a decrease in the steady-state average productivity of roughly 0.5 percent compared to the optimum’s steady-state. This decrease in productivity is not innocuous: it leads to a doubling of the welfare cost of inflation.

It has been very difficult to find substantial costs for inflation, in a large part because it is difficult to make money matter in significant ways in a microfounded model. This attempt is different in that the welfare cost comes from productivity losses through the firm entry and distribution. The resulting impact of money and inflation is indirect yet important.

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