Welfare Costs of Inflation in a Menu Cost Model

Recent years have seen substantial progress in our understanding of pricing decisions at the micro level. Access to large scale data sources on prices at the level of individual products has given us rich information on how frequently prices change, by what magnitudes, and how the aggregation of price changes in individual firms maps into aggregate inflation (see, among many others, Mark Bils and Peter J. Klenow 2005). These facts about price movements are a key input in recent quantitative models of the aggregate effects of nominal rigidities (e.g. Mikhail Golosov and Robert E. Lucas 2007). In this paper, we use both the new facts and the new quantitative models to revisit an old question, namely, that of quantifying the welfare benefits of low inflation. Our model includes two channels through which steady-state inflation affects welfare. The first channel is based on the presence of nominal rigidities, which induce fluctuations in relative prices between products whose prices adjust, and products whose prices remain fixed, thus distorting the composition of output away from efficiency, and lowering aggregate productivity and welfare. These relative price distortions are eliminated when inflation is zero, so that the need for price adjustment is eliminated. This argument is at the core of a large literature on optimal monetary policy (see, for example, Michael Woodford 2003). The second channel, dating back to Milton Friedman (1969) and more recently Lucas (2000), stems from the effects of inflation on the opportunity cost of holding real money balances.1 ∗Burstein and Hellwig: Department of Economics, UCLA, Los Angeles CA 90095 1Other references include Jordi Gali (2007) and Stephanie Schmitt-Grohe, and Martin Uribe (2005) for