The Welfare Costs of Inflation with Two Alternative Means of Payment: Money and Trade Credit

This paper quantifies the magnitude of welfare losses that result in steady state due to a moderate to high inflation tax. In the economy, both money and trade credit provide transactions services and the mix of two alternative means of payment is endogenous. With an explicit transactions technology parameterized to mimic the way U .S. households use cash and other means of payment in making their transactions, a weï¬ are cost of 2.89% of output results from a 10% annual inflation rate relative to the Friedman (I969) rule. The estimate of welfare costs of inflation captures the fact that the consumer inefficiently economizes on her holdings of real money balances in the face of positive irï¬ ation tax by purchasing a wider range of goods with trade credit that uses up real resources as well as the fact that moderate inflation rates cause people to inï¬ ciently substitute away from goods for leisure. In addition to this substitution eflect, however, there, is a dominant negative wealth effect associated with higher inflation rates. The result strengthens the view that regards price stability as the most widely-cited objective for monetary policy.