Inflation taxes, financial intermediation, and home production

Abstract

This paper examines the welfare costs of inflation in the presence of financial market frictions. The results suggest that financing constraints on firms' working capital expenditures significantly increase the welfare costs relative to the standard Cooley-Hansen (1989) cash-in-advance framework. These costs are reduced, but remain above those computed by Cooley and Hansen, when a financial intermediary is introduced that engages in asset transformation by creating liquid, interest-bearing deposit accounts and using the proceeds to finance working capital loans to firms. Explicitly modeling home production activities tends to reduce the distortion that inflation induces in employment and market output, but results in higher estimates of the welfare losses. Both of these effects are magnified when households must also finance their gross investment in home capital by borrowing from the financial intermediary. This credit friction indirectly taxes home production and tends to move resources back into the market, thereby mitigating the adverse effects of inflation on employment and output, while exacerbating the welfare costs.Inflation (Finance) ; Welfare ; Housing - Finance