Measuring the Welfare Costs of Inflation in a Life-cycle Model∗

The welfare costs of inflation are analyzed in a life-cycle model. In the benchmark model, money is held to satisfy a cash-in-advance constraint. An inflation rate over 200% per annum maximizes lifetime utility because it leads to better smoothing of utility over the life-cycle, in essence because inflation taxes rich, old agents and makes net transfers to poor, young ones. This version of the model suggests that high inflation in developing countries may be part of an optimumpolicy. Introducing other taxes into the model gives the government alternative sources of revenue and reduces the optimal inflation rate to something close to the Friedman rule. Allowing some goods to be purchased with costly credit also reduces the optimal (lifetime utilitymaximizing) inflation rate. However, if seigniorage revenue can be used to lower these other taxes, high inflation is again optimal. Finally, the transitional dynamics following a disinflation are traced out for the costly credit version of the model with U.S. taxes. This policy leads to a Pareto superior allocation. ∗The views expressed herein do not necessarily reflect those of the Federal Reserve Bank of Cleveland or of the Federal Reserve System.