In macroeconomics

Macroeconomics

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, the welfare cost of inflation refers to the analyses of changes in social welfare

Welfare economics

Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

 caused by inflation

Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

.

The traditional approach, developed by Bailey (1956) and Friedman

Milton Friedman

Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 (1969), treats real money balances as a consumption good

Consumption (economics)

Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...

 and inflation as a tax

Tax

To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 on real balances. This approach measures the welfare cost by computing the appropriate area under the money demand curve

Demand curve

In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule...

. Fischer

Stanley Fischer

Stanley "Stan" Fischer is an American-Israeli economist and the current Governor of the Bank of Israel. He previously served as Chief Economist at the World Bank.-Biography:...

 (1981) and Lucas

Robert Lucas, Jr.

Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

 (1981), find the cost of inflation to be low. Fischer computes the deadweight loss

Deadweight loss

In economics, a deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal...

 generated by an increase in inflation from zero to 10 percent as just 0.3 percent of GDP using the monetary base

Monetary base

In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

 as the definition of money. Lucas places the cost of a 10 percent inflation at 0.45 percent of GDP using M1

Money supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 as the measure of money. Lucas (2000) revised his estimate upward, to slightly less than 1 percent of GDP. Ireland (2009) extends this line of analysis to study the recent behavior of U.S. money demand.

Structural models are a recent alternative to econometric estimates of the triangle under an estimated money demand curve. Cooley

Thomas F. Cooley

Thomas Ferguson Cooley is the Paganelli-Bull Professor of Economics at the New York University Stern School of Business. He served as Dean of the Stern School from 2002 to January 2010. He is also a Professor of Economics in the NYU Faculty of Arts and Science...

 and Hansen (1989) calibrate a cash-in-advance version

Cash-in-advance constraint

The cash-in-advance constraint is an idea used in economic theory to capture monetary phenomena...

 of a business cycle model. They find that the welfare cost of 10 per cent inflation is about 0.4 per cent of GNP. Among recent general-equilibrium models that estimate the welfare cost of inflation are Dotsey and Ireland (1996), Aiyagari, Braun, and Eckstein (1998), Burstein and Hellwig (2008), and Henriksen and Kydland (2010).

Craig and Rocheteau (2008) argue that a search-theoretic framework

Search theory

In microeconomics, search theory studies buyers or sellers who cannot instantly find a trading partner, and must therefore search for a partner prior to transacting....

 is necessary for appropriately measuring the welfare cost of inflation. Lagos and Wright

Randall Wright

Randall D. Wright is a Canadian academic macroeconomist who advanced the fields of monetary economics and labor economics through his role in the development of matching theory.- Biography :...

(2005) model monetary exchange and provide estimates for the annual cost of 10 percent inflation to be between 3 and 4 percent of GDP.