Ongoing, massive liquidity injections by the U.S. central bank are raising fears of significant long run inflation and, with it, questions about the likely economic impact. Studies based on representative agent models of the U.S. economy generally point to a negative, monotonic association between long run inflation and social welfare. Put simply, most study finds that a representative household would trade off some consumption for zero inflation, though the deadweight loss from moderate inflation quantitatively amounts to a fraction of one percent of consumption. Hence, from the vantage point of a representative agent the optimal policy prescription is non-inflationary, and departures from this policy are not very costly.
But field economies are not populated by representative agents, so distributional issues must be taken into account. Survey evidence reported in Easterly and Fischer (2001), for instance, suggests that low-income households are more concerned about inflation than wealthier households. Unfortunately, there is only a handful of studies about the impact of inflation in heterogeneous-agent economies, with results that often contrast on the most basic matters, such as how inflation affects the distribution of wealth—which is the key aggregate state variable–whether there are social gains from targeting low inflation and, if so, how large they are, quantitatively.
This paper reports results from a study of long-run inflation when inequality in wealth and consumption arise endogenously. The model is a production economy in which ex-ante homogeneous households hold money to trade on spot markets and to self-insure against idiosyncratic productivity shocks. Precautionary savings needs can also be satisfied by holding riskless debt securities that are illiquid. There is no aggregate risk. In stationary equilibrium productivity shocks induce heterogeneity in income and therefore, in wealth and consumption. Due to incomplete markets, the allocation is inefficient. Long-run inflation, which results from lump-sum monetary injections, alters the distribution of disposable income, of wealth and of consumption and, therefore, affect the (in)efficiency of the allocation.
Equilibrium is computationally studied for a model calibrated to the U.S. economy, post 1929. The analysis offers several new insights about the impact of long-run inflation on key macroeconomic variables and it suggests that disparities in earlier results can be reconciled with disparities in either the assumed financial structure or in the persistence of shocks.
First, we report that when inflation is generated through lump-sum money creation, higher inflation lowers inequality in disposable income, but it permanently reduces overall income and, hence, depresses aggregate consumption. Therefore, inflation can improve average welfare only if it is capable to sufficiently reduce consumption inequality, which is zero in the efficient allocation.
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Understanding the Distributional Impact of Inflation
