“Liquidity and Welfare in a Heterogeneous-Agent Economy” by Yi WEN
Federal Reserve Bank of St. Louis
This paper constructs a tractable incomplete-market model to study the effects of monetary policies in an environment where money serves as a store of value and provides liquidity to smooth consumption. The model can generate sluggish movements in aggregate price and positive responses from aggregate output to transitory money injections despite .flexible prices. However, permanent money growth can be extremely costly: With log utility function and an endogenously determined distribution of money balances that matches the household data, agents are willing to reduce consumption by 20% (or more) to avoid 10% annual inflation. The large welfare cost of inflation arises because inflation destroys the liquidity value and the buffer- stock function of money, thus raising the volatility of consumption for low-income households. The astonishingly large welfare cost of moderate inflation provides a justification for adopting a low inflation target by central banks and offers an explanation for the empirical relationship between inflation and social unrest in developing countries.