How Costly is Sustained Low Inflation for the U.S. Economy?

Abstract

In this paper we describe and analyze a quantitative-theoretic general equilibrium model in which permanent changes in monetary policy have important welfare consequences for households. Our main findings are estimates of the welfare cost of inflation that are an order of magnitude larger than most estimates found in the cost-of-inflation literature. In particular, we find that a permanent, 10-percentage-point increase in the inflation rate—a standard experiment in this literature—imposes an annual welfare loss equivalent to 11.2 percent of output. Most estimates of the cost of inflation place this loss at less than 1 percent of output. Thus, our analysis helps account for the widely held view that the benefits of reducing the inflation rate from the double-digit levels experienced during the 1970s were very large. The model we employ belongs to a class of models—the overlapping generations (OLG) or general equilibrium life-cycle models—that have rarely been used to study the cost of inflation and have never been used to obtain practical estimates of the magnitude of these costs. The distinctive features of the model allow us to study a source of welfare losses from inflation that has not been described previously. Although our analysis is novel in these respects, in most other ways it is entirely conventional. We make standard assumptions about preferences, production, and capital accumulation. Households and firms have rational expectations, and equilibria occur at prices and interest rates that clear markets. Money demand is introduced through a reserve requirement. Changes in monetary policy

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