A Research On The Welfare Cost Of Inflation And Seigniorage In China

Since economic reform and opening to the outside world, Chinese economy hasacquired remarkable achievements, living standards have improved significantly. At thesame time, the price level of China also increased rapidly. In China, a major indicator ofinflation measurement is Consumer Price Index (CPI). China’s CPI has increased5.2times from1978to2010. During last30years, China has experienced two relative higherinflation periods, one in1988and one in1994, and the inflation rates (measured by CPI)were18.8%and24.1%respectively. In2008, China’s CPI increased to5.85%, which isthe highest level in recent10years. The proactive fiscal policy and loose monetary policyhighlighted by the4trillion bailout plan in2008, has brought a new round of priceincreasing and the rising trend is continuing.Inflation has always been a hot issue of concern to economists. On the one hand,governments could obtain seigniorage revenue from inflation; on the other hand, citizenssuffer from welfare losses from it. So seigniorage and welfare cost of inflation has been ahot issue for half a century. However, foreign economists seem more inclined to studythe high inflation case, and related fewer researches focus on moderate inflation countrieslike China. Scholars in China basically study seigniorage and the welfare cost of inflationseparately. Even if the very few research which combining them together are essentiallyfrom the theoretical perspective. There is no research in China studying seigniorage andthe welfare cost of inflation together from theoretical and empirical perspective. And thisis the purpose of this dissertation.Based on the general equilibrium research framework of Eckstein and Leiderman(1992) and data of China in1978-2010, applying Hansen (1982) GMM method ofestimation, we estimate the model parameters and calculate the implied seignioragerevenue and the welfare cost of inflation. Firstly, we based on our analysis on theEckstein and Leiderman (1992) model, a simplified model, and a model replaced theCobb-Douglas utility function with a constant elasticity of substitution (CES) utilityfunction: estimating the model parameters, calculating the implied seigniorage revenueand the welfare cost of inflation, estimating the upper and lower limits of seignioragerevenue and the welfare cost of inflation, and comparing our results with the results of Eckstein and Leiderman (1992) which were based on Israel data. Secondly, sincegovernments typically levy the inflation tax on non-interest-bearing required reserves ofthe banking system as well as on currency held by the public, we introduced a bankingsector into our basic theoretical models, and discuss how deposit reserve ratio influenceon the welfare cost of inflation and seigniorage revenue. Finally, we general discussedthe characteristics of seigniorage, welfare cost of inflation of China during last30years.We have the following findings. For the same level of inflation rate, seigniorage andthe welfare cost of inflation in1978-2010in China are lower than the level of Israel in1970-1988l. However, both the level of seigniorage and the size of welfare cost ofinflation based on CES utility function are higher. The upper limit of seigniorage and thewelfare cost of inflation based on Cobb-Douglas utility function are0.0281and0.0801respectively. The upper limit of seigniorage and the welfare cost of inflation based onCES utility function are0.077and0.1065respectively. The upper limit of seigniorageand the welfare cost of inflation based on Cobb-Douglas utility function with a bankingsector are0.0426and0.0655respectively. The upper limit of seigniorage and the welfarecost of inflation based on the CES utility function with a banking sector are0.0564and0.0677respectively. The maximum seigniorage is0.2829, which is based theCobb-Douglas and CES utility function with a banking sector. The results of seigniorageare lower, based on Cobb-Douglas and CES utility function with a banking sector. Theseigniorage revenue estimated by Zhang Jianhua and Zhang Huaiqing (2009) is higherthan ours. The overall trend of the welfare cost of inflation estimated in a variety of waysis generally consistent. However, the size of welfare cost of inflation based on CESutility function is higher, the size of welfare cost of inflation based on CES utilityfunction with a banking sector is lower, and it is possible to tradeoff the welfare cost ofinflation and seigniorage revenue with the deposit reserve ratio.