How Costly is Sustained Low Inflation for the U.S. Economy?
The authors study the welfare cost of inflation in a general equilibrium life-cycle model that includes households that live for many periods, production and capital, simple monetary and financial sectors, and a fairly elaborate government sector. The governments taxation of capital income is not indexed for inflation. They find that a plausibly calibrated version of this model has a steady state that matches a variety of facts about the postwar U.S. economy. They use the model to estimate the welfare cost of permanent, policy-induced changes in the inflation rate and find that most of the costs of inflation are direct and indirect consequences of the fact that inflation increases the effective tax rate on capital income. The cost estimates are an order of magnitude larger than other estimates in the literature.