The Cost Of Inflation: A Mechanism Design Approach

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A classical topic in monetary economics is measuring the burden that inflation imposes on society. The standard methodology, pioneered by Bailey (1956) and Friedman (1969) and reviewed in Lucas (2000), consists of estimating a reduced-form money demand function and measuring the welfare cost of inflation as the area underneath money demand.1 The rationale for this approach is based on competitive general equilibrium models where money enters the utility function, or a cash-in-advance constraint.2 Unfortunately, as pointed out by Wallace (2001), such models contain hidden inconsistencies and they are ill-suited for normative analysis as they fail to account for the social benefits that monetary exchange provides to the economy.