Inflation taxes, financial intermediation, and home production

This paper examines the incidence and welfare costs of inflation in the presence of financial market frictions and home production. The results suggest that financing constraints on firms' working capital expenditures significantly increase the welfare costs relative to the standard Cooley-Hansen (1989) cash-in-advance framework. These costs are reduced, but remain above those computed by Cooley and Hansen, when a financial intermediary is introduced that engages in asset transformation by creating liquid, interest-bearing deposit accounts and uses the proceeds to finance working capital loans to firms. Explicitly modeling home production activities tends to exacerbate the distortions that inflation induces in employment and market output to a considerable degree, and suggests that welfare costs of anticipated inflation may be substantially higher than previous estimates. Sensitivity analysis indicates that the magnitude of the market response to inflation and the attendant welfare costs of inflation depend strongly on the elasticity of substitution between capital and labor in home production, and to a much lesser degree on the elasticity of substitution between home and market consumption. When households must also finance their gross investment in home capital by borrowing from the financial intermediary, home production is indirectly taxed by inflation. As a result of this credit friction, resources thus tend to move back into the market, thereby mitigating the adverse effects of inflation on employment and output, while further increasing the welfare losses.