On the Instability of Long‐Run Money Demand and the Welfare Cost of Inflation in the United States

We evaluate the policy implications of measuring the welfare cost of inflation accounting for instabilities in the long‐run money demand for the United States over the period 1900–2013. We extend the analysis and reassess the results reported in Lucas (2000) and Ireland (2009), also considering the recent theoretical contributions of Lucas and Nicolini (2015) and Berentsen, Huber, and Marchesiani (2015). Breaks in the long‐run money demand give rise to regime‐dependent welfare cost estimates. We find that the welfare cost is about 0.1% of annual income over 1976–2013, as compared to 0.8% over 1945–75. Overall, these values are substantially lower than those reported in the literature.     

Inflation and Welfare in Long‐Run Equilibrium with Firm Dynamics

We analyze the welfare cost of inflation in a model with a cash‐in‐advance constraint and an endogenous distribution of establishments' productivities. Inflation distorts aggregate productivity through firm entry dynamics. The model is calibrated to the U.S. economy and the long‐run equilibrium properties are compared at low and high inflation. When the period over which the cash‐in‐advance constraint is binding is one quarter, an annual inflation rate of 10% leads to a decrease in average productivity of roughly 0.5% compared to the optimum. This decrease is not innocuous: it leads to a doubling of the welfare cost of inflation.     

A New Model of Inflation,Trend Inflation,and Long‐Run Inflation Expectations

This paper develops a bivariate model of inflation and a survey‐based long‐run forecast of inflation that allows for the estimation of the link between trend inflation and the long‐run forecast. Thus, our model allows for the possibilities that long‐run forecasts taken from surveys can be equated with trend inflation, that the two are completely unrelated, or anything in between. Using a variety of inflation measures and survey‐based forecasts for several countries, we find that long‐run forecasts can provide substantial help in refining estimates and fitting and forecasting inflation. It is less helpful to simply equate trend inflation with the long‐run forecasts.     

Long‐Run Inflation and the Distorting Effects of Sticky Wages and Technical Change

We show that the Calvo price‐setting model is not necessarily inconsistent with evidence of a weak relation between positive trend inflation and price dispersion. We identify the interaction between sticky wages and technical change as factors disrupting the allocative role of the wage system under positive trend inflation. In turn, this interaction generates inefficient wage dispersion, as opposed to price dispersion, which fuels inflation costs. We conclude that it is too early to dismiss the New Keynesian model as a useful vehicle to assess the costs of inflation.     

Why Money Growth Determines Inflation in the Long Run: Answering the Woodford Critique

Woodford argues that it is not appropriate to regard inflation in the steady state of New Keynesian models as determined by steady‐state money growth. Woodford instead argues that the intercept term in the monetary authority's interest rate policy rule determines steady‐state inflation. In this paper, I offer an alternative interpretation of steady‐state behavior, according to which it is appropriate to regard steady‐state inflation as determined by steady‐state money growth. The argument relies on traditional interpretations of the central bank's power in the long run and appeals to model properties that are common to textbook and New Keynesian analysis. According to this argument, the only way the central bank can control interest rates in the long run is via affecting inflation, and its only means available for determining inflation is by determining the money growth rate.     

Financial Innovations,Money Demand,and the Welfare Cost of Inflation

In the 1990s, the empirical relationship between money demand and interest rates began to fall apart. We analyze to what extent financial innovations can explain this breakdown. For this purpose, we construct a microfounded monetary model with a money market that provides insurance against liquidity shocks by offering short‐term loans and by paying interest on money market deposits. We calibrate the model to U.S. data and find that the introduction of the sweep technology at the beginning of the 1990s, which improved access to money markets, can explain the behavior of money demand very well. Furthermore, by allowing a more efficient allocation of money, the welfare cost of inflation decreased substantially.     

On the Asymmetric U‐Shaped Relationship between Inflation,Inflation Uncertainty,and Relative Price Skewness in the UK

We investigate the asymmetric relationships between aggregate inflation and the second and third moments of the cross‐sectional distribution of relative prices using a modified Calvo pricing model with regime‐dependent price rigidities. Calibration experiments reveal that the inflation‐standard deviation and inflation‐skewness relationships exhibit U‐shaped asymmetries around the historical mean inflation rate. UK sectoral data support our results. We conclude that monetary policy should target an inflation rate proximate to the (common) minima of these nonlinear relationships and that core inflation measures should not be used for policy purposes as they exclude much of the information contained in the higher moments.     

Long‐Term Effects of Fiscal Policy on the Size and Distribution of the Pie in the UK*

This paper provides a joint analysis of the output and distributional long‐term effects of various fiscal policies in the UK, using a vector autoregression (VAR) approach. Our findings suggest that the long‐term impact on GDP of increasing public spending and taxes is negative, and especially strong in the case of current expenditure. We also find significant distributional effects associated with fiscal policies, indicating that an increase in public spending reduces inequality while a rise in indirect taxes increases income inequality.     

Inflation and inequality

Cross-country evidence on inflation and income inequality suggests that they are positively related. This article explores the hypothesis that this correlation is the outcome of a distributional conflict underlying the determination of government policies. A political economy model is presented in which equilibrium inflation is positively related to the degree of inequality in income due to the relative vulnerability to inflation of low income households.     

Moderate Inflation and the Deflation–Depression Link

Recent research has concluded that the historical evidence only provides weak support for the contention that deflation episodes are harmful to economic growth. In this paper, we revisit this relationship by allowing for inflation and growth to have a nonlinear specification dependent on inflation levels. In particular, we allow for the possibility that high inflation is negatively correlated with growth, while a positive relationship exists over the range of negative to moderate inflation. Our results confirm a positive relationship between inflation and growth at moderate inflation levels, and support the contention that the relationship between inflation and growth is nonlinear over the entire sample range.     

The Distributional Impact of the Greek Crisis in 2010*

The severe economic crisis affecting Greece is widely thought to be having a significant social impact in terms of greater inequality and increased poverty. We provide an early assessment of whether (and to what extent) this was the case in 2010, the first year of the Greek crisis. We distinguish between two interrelated factors: on the one hand, the austerity policies taken to reduce fiscal deficits; on the other hand, the wider recession. Using a tax–benefit model, we attempt to quantify the distributional implications of both. With respect to the austerity policies, we focus on the changes affecting taxation, pension benefits and public sector pay. With respect to the wider recession, we model the effects of rising unemployment and inflation, as well as of lower earnings for self-employed workers and for employees of private firms. In simulating the impact of these changes on the distribution of incomes (and in estimating how the total burden of the crisis is shared across income groups), we take into account tax evasion and benefit non-take-up. We conclude by discussing the main findings, methodological pitfalls and policy implications of our research.     

Are Expected Inflation Rates and Expected Real Rates Negatively Correlated? A Long‐Run Test of the Mundell‐Tobin Hypothesis

Some empirical evidence suggests that the expected real interest and expected inflation rates are negatively correlated. This hypothesis of negative correlation is sometimes known as the Mundell‐Tobin hypothesis. In this article we reinvestigate this negative relation from a long‐term point of view using cointegration analysis. The data on the historical interest rate on T‐bills and the inflation rate indicate that the Mundell‐Tobin hypothesis does not hold in the long run for the United States, the United Kingdom, and Canada. We also obtain similar results using the real interest rate on index‐linked gilt traded in the United Kingdom.     

Foreign Demand for Domestic Currency and the Optimal Rate of Inflation

We characterize the Ramsey optimal rate of inflation in a model with a foreign demand for domestic currency. In the absence of such demand, the model implies that the Friedman rule—deflation at the real rate of interest—is optimal. We show analytically that in the presence of a foreign demand for domestic currency, this result breaks down. Calibrated versions of the model deliver optimal annual rates of inflation between 2% and 10%. The domestically benevolent government imposes an inflation tax to extract resources from the rest of the world in the form of seignorage revenue.     

An Investigation of the Short‐Run and Long‐Run Stock Returns Surrounding Insurer Rating Changes

We find that stock returns move in the direction of insurer rating changes in the 12‐month period prior to the announcement. There is an additional stock price response following the announcement of a downgrade, but no response to upgrade announcements. The reaction to a downgrade is more pronounced when it involves a smaller insurer, when it spans multiple levels, or when it is a threshold downgrade. Returns are significantly more negative during the 12 months leading up to a downgrade announcement during the financial crisis (2008 and 2009) compared to other sample years.     

A Long‐Run Performance Perspective on the Technology Bubble

The events surrounding the stock price peak of March 2000 are commonly interpreted as the bursting of a technology or Internet bubble, with some researchers pointing out that the pattern could also arise in fundamental models. We inform the debate by studying the long‐run performance of Internet and technology stocks from March 2000 onward. Using calendar‐time regressions, we do not find conclusive evidence of negative abnormal returns. The results are consistent with a new interpretation of the events; namely, the price drop of the early 2000s was not warranted in light of future cash flows and risk.     

Long‐Run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention

We study the portfolio decision of a household with limited information‐processing capacity (rational inattention [RI]) in a setting with recursive utility. We find that RI combined with a preference for early resolution of uncertainty could lead to a significant drop in the share of portfolios held in risky assets, even when the departure from the standard expected utility setting with full‐information rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long‐run risk and thus require higher compensation in equilibrium.     

Stock Returns and Volatility: Pricing the Short‐Run and Long‐Run Components of Market Risk

We explore the cross‐sectional pricing of volatility risk by decomposing equity market volatility into short‐ and long‐run components. Our finding that prices of risk are negative and significant for both volatility components implies that investors pay for insurance against increases in volatility, even if those increases have little persistence. The short‐run component captures market skewness risk, which we interpret as a measure of the tightness of financial constraints. The long‐run component relates to business cycle risk. Furthermore, a three‐factor pricing model with the market return and the two volatility components compares favorably to benchmark models.     

The Happiness Trade‐Off between Unemployment and Inflation

Unemployment and inflation lower well‐being. The macroeconomist Arthur Okun characterized the negative effects of unemployment and inflation by the misery index—the sum of the unemployment and inflation rates. This paper makes use of a large European data set, covering the period 1975–2013, to estimate happiness equations in which an individual subjective measure of life satisfaction is regressed against unemployment and inflation rate (controlling for personal characteristics, country, and year fixed effects). We find, conventionally, that both higher unemployment and higher inflation lower well‐being. We also discover that unemployment depresses well‐being more than inflation. We characterize this well‐being trade‐off between unemployment and inflation using what we describe as the misery ratio. Our estimates with European data imply that a 1 percentage point increase in the unemployment rate lowers well‐being by more than five times as much as a 1 percentage point increase in the inflation rate.