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Liquidity Effects and the Welfare Costs of Inflation in an Endogenous Growth Model

The paper has two subjects. The first subject is the development of a monetary general equilibrium model with endogenous growth. By combining the two-sector endogenous growth model and the limited participation approach, the model is able to explain the empirically observed liquidity effect of an expansionary monetary policy. The second subject is the effect of inflation on growth and economic welfare. It is shown that the traditional approach to measure the welfare costs of inflation may be misleading: It ignores the costs or benefits of the transition to the new steady state. This omission may bias estimates of the optimal degree and of the total benefits of disinflation. It is also argued that, once the transition is taken into account, the welfare gains of lowering inflation depend on the monetary policy rule and the fiscal response to disinflation. The two themes of the paper are related. Given that the welfare costs of inflation depend on the transitional dynamics, then simulating disinflation processes requires models with sensible short run properties.