Welfare Costs of Inflation and Interest-Bearing Money

Abstract

This work extends the Lucas' analysis of the welfare cost of inflation to an economy with interest-bearing deposits. Lower and upper bounds to Lucas' measure of the welfare cost of inflation are also provided. The upper bound is shown to lie between Lucas' measure of the welfare cost of inflation and the area under the money-demand curve. STARTING WITH MARTIN BAILEY in 1956, the literature on welfare costs of inflation has recently been enriched by contributions, among others, by Lucas (1993, 2000), Dotsey and Ireland (1996), and Gillman (1993, 1995). It remains yet to adequately integrate the banking sector in this process. This work extends Lucas' analysis of the welfare cost of inflation developed in the McCallumGoodfriend (1987) framework to an economy with interest-bearing deposits. Lower and upper bounds to Lucas' measure of the welfare cost of inflation are also provided. The upper bound is shown to lie between Lucas' measure and the area under the money-demand curve which characterizes Bailey's method (1956) for calculating the welfare cost of inflation.