Welfare Cost of (Low) Inflation: A General Equilibrium Perspective

IMF Working Papers, August 1, 1998

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Provides general equilibrium estimates of the steady-state welfare gains of lowering inflation from a low level to close to price stability.
Uses an overlapping-generations growth model.
Money demand is modeled on the basis that real money balances are a factor of production.
Main quantitative conclusion: the welfare cost of low (positive) inflation is quantitatively very modest — under 0.2 percent of GDP annually within reasonable ranges of all parameter values.
Qualitative result: inflation unambiguously reduces capital intensity, drives up the before-tax real rate of return to capital, and unambiguously imposes a life-time welfare cost.

Framework: overlapping-generations growth model.
Money demand specification: real money balances enter as a factor of production.
Asset return relation: assumes a standard Fisher equation modified by the presence of an income tax.
Taxation: presence of an income tax affects the Fisher equation and hence real returns.

Welfare cost estimate: under 0.2 percent of GDP annually (within reasonable parameter ranges).
Effects on capital and returns:
- Inflation reduces capital intensity (unambiguous).
- Inflation increases the before-tax real rate of return to capital (unambiguous).
Welfare implication: inflation imposes a life-time welfare cost (unambiguous), but the magnitude is modest as quantified above.

Lowering inflation from a low level toward price stability yields steady-state welfare gains, but the quantified gains are small (under 0.2 percent of GDP annually).
Given the model’s structure and parameter sensitivity, policy trade-offs involving the costs and benefits of reducing already-low inflation should account for the modest quantitative welfare gains highlighted.

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