Bailey's Measure of the Welfare Costs of Inflation as a General-Equilibrium Measure

Lucas (2000) has shown that Bailey's formula for the welfare costs of inflation can be regarded as an approximation to the general-equilibrium measures that emerge from the Sidrauski and the shopping-time models. In this paper we show that Bailey's measure can be exactly obtained in the Sidrauski general-equilibrium framework under the assumption of quasilinear preferences. The result, based on whether or not wealth effects are incorporated into the analysis, is also helpful in clarifying why Lucas' measure derived from the Sidrauski model turns out to be an upper bound to Bailey's. Two examples are used to illustrate the main conclusions.     

Alternative central bank credit policies for liquidity provision in a model of payments

I explore alternative central bank policies for liquidity provision in a model of payments. I use a mechanism design approach so that agents’ incentives to default are explicit and contingent on the credit policy designed. In the first policy, the central bank invests in costly enforcement and charges an interest rate to recover costs. I show that the second-best solution is not distortionary. In the second policy, the central bank requires collateral. If collateral does not bear an opportunity cost, then the solution is first best. Otherwise, the second best is distortionary because collateral serves as a binding credit constraint.     

Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves

This paper analyses the UK interest rate term structure over the period since October 1992, when the United Kingdom adopted an explicit inflation target, using an affine term structure model estimated using both government bond yields and survey data. The model imposes no-arbitrage restrictions across nominal and real yields, which enables interest rates to be decomposed into expected real policy rates, expected inflation, real term premia and inflation risk premia. The model is used to shed light on major developments over the period, including the impact of Bank of England independence and the low real bond yield ‘conundrum’.     

Monetary Equilibrium and the Cost of Banking Activity

We investigate the effects of banks' operating costs on allocations and welfare in a low interest rate environment. We introduce an explicit production function for banks in a microfounded model where banks employ labor resources, hired on a competitive market, to run their operations. In equilibrium, this generates a spread between interest rates on loans and deposits, which reflects the underlying monetary policy and the efficiency of financial intermediation. In a deflation or low-inflation environment, equilibrium deposits yield zero returns. Hence, banks soak up labor resources to offer deposits that do not outperform idle balances, thus reducing aggregate efficiency.     

Do the ASEAN countries and Taiwan form a common currency area?

Common currency areas and Asian common currency areas in particular are highly topical and somewhat controversial areas for research. We explore the hypothesis that the members of the Association of Southeast Asian Nations meet necessary conditions for forming a common currency area and whether Taiwan appears a natural member of such an area. We test data on the ASEAN countries and Taiwan for consistency with a common currency area. We produce the first evidence that these five ASEAN countries and the ASEAN countries plus Taiwan meet the microeconomic criteria to form a common currency area.     

Efficiency improvement from restricting the liquidity of nominal bonds

In a monetary search model with nominal bonds, agents face matching/taste shocks but they cannot insure, borrow or trade against such shocks. A government imposes a legal restriction that prohibits bonds from being used to buy a subset of goods. I show that this legal restriction can increase the society's welfare. In contrast to the literature, this efficiency role persists in the steady state and even when the households cannot trade assets after receiving the shocks. Moreover, it can exist when the Friedman rule is available and when the restriction is only obeyed by government agents.     

Heterogeneity and Lotteries in Monetary Search Models

We introduce ex ante heterogeneity into the Berentsen, Molico, and Wright monetary search model with lotteries. We show that their three main results regarding lotteries do not survive this modification of the environment.     

The Eurozone needs exit rules

This study argues that the key issue for defining and solving the Eurozone’s (EZ) difficulties lies in readjusting the relationship between the centre and the periphery of the EZ. Our argument proceeds in two steps. Firstly, the basic finance problem of a centre-periphery system is captured by a threat game with complete but imperfect information. To get close to the essence of the current EZ sovereign debt crisis we analyse to what extent a ‘troubled’ periphery member can negotiate a bailout from the centre due to the existence of a negative externality arising from its potential default. Secondly, we analyse how establishing ‘exit rules’ would shift the centre-periphery relationship in a way that safeguards the stability of the EZ. We demonstrate that such rules may help limit the scope for brinkmanship whereby fiscal problems in one member state create a negative externality for the rest of the EZ. We then discuss key policy implications concerning financial aspects of the centre-periphery relationship within the EZ.     

A model of money with multilateral matching

We develop a model of decentralized monetary exchange to examine the distributional effects of inflation across heterogeneous agents. The agents have private information about their productivity, preferences, or money holdings. Matching is multilateral and each seller is visited by a stochastic number of buyers. The good is allocated according to a second-price auction in money. In equilibrium, homogeneous buyers hold different amounts of money leading to price dispersion. We find the closed-form solution for the distribution of money holdings. Entry of sellers is suboptimal except at the Friedman rule. Inflation acts as a regressive tax.     

Float on a note

From 1863-1914, banks in the U.S. could issue notes subject to full collateral, a tax on outstanding notes, redemption of notes on demand, and a clearing fee per issued note cleared through the Treasury. The system failed to satisfy a purported arbitrage condition: the yield on collateral exceeded the tax rate plus the product of the clearing fee and the average clearing rate of notes. The failure is explained by a model in which note issuers choose to issue notes only in trades that produce a low clearing rate (high float), but in which there are diminishing returns to additional note issue.     

A note on “Inflation and Welfare”

This note provides an analytical confirmation and a refinement of [Lucas Jr., R.E., 2000. Inflation and welfare. Econometrica 68 (62), 247–274 (March)] numerical findings regarding the characterization of optimality in the shopping-time model presented in that paper. The original numerical analysis concludes that a coefficient of risk aversion (σ) greater than 0.01 is sufficient for optimality. Here we use Arrow’s sufficiency theorem to confirm this result and, more importantly, to show without more calculations how changes in parameters can affect it.     

Inflation dynamics: A cross-country investigation

We document that “persistent and lagged” inflation (with respect to output) is a world-wide phenomenon in that these short-run inflation dynamics are highly synchronized across countries. In particular, the average cross-country correlation of inflation is significantly and systematically stronger than that of output, while the cross-country correlation of money growth is essentially zero. We investigate whether standard monetary models driven by monetary shocks are consistent with the empirical facts. We find that neither the new Keynesian sticky-price model nor the sticky-information model can fully explain the data. An independent contribution of the paper is to provide a simple solution technique for solving general equilibrium models with sticky information.