This paper applies new computational methods for studying nonstationary dynamics to reevaluate the welfare cost of inflation. A dynamic stochastic general equilibrium model with heterogeneous agents is studied. Incomplete markets induce agents to hold a fiat currency as insurance against idiosyncratic income fluctuations. Rather than comparing steady state equilibria, I measure the welfare cost of inflation by explicitly modeling the transitional dynamics that arise following a change in monetary policy. Transitional dynamics are shown to increase the welfare cost of inflation substantially. Also, contrary to conventional wisdom, transitional dynamic effects are shown to increase the benefits of reducing the inflation rate.
JEL classification: E4, E5
Key words: transitional dynamics, welfare cost of inflation, computable DSGE model
This paper was formerly titled "The Welfare Cost of Monetary Policy." The author thanks seminar participants at Stanford and Indiana Universities, IUPUI, and the Federal Reserve Banks of Atlanta and St. Louis for helpful comments. He especially thanks his advisors, Ken Judd and Tom Sargent, for their advice and encouragement during the writing of his Ph.D. dissertation, from which this paper was born. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.
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