Welfare Cost Of Inflation

Chinese Economy has been undergoing a high rate growth in recent years, the GDP in 2008 is more than two and half times than 2000.But as the economy growth was accelerating, much more surplus was deteriorating the international balance of payment, pressure of appreciation for RMB was aggregating and international resources price was climbing, the inflation problem in domestic was emerging and became a hot issue for public, governors and economists. The inflation rate has been kept high since 2004, it rose to a record high in the first quarter in 2008.Inflation has been always one of the most important issues for economists. So far, there was no certain conclusion on the real effect that inflation did on the economy. Some economists argue that estimated inflation have positive effect on real economy, which means moderate inflation could produce more employment opportunities and increase real output. However, other economists who disagree this point of view believe that even moderate and estimated inflation could hurt the economy with much welfare cost. They also attribute the cause of hyper inflation was just moderate inflation. Otherwise, whether it's necessary for policy makers to implement positive fiscal and monetary policy to smoothen the economy fluctuation was a controversial issue too.Therefore, there was a necessity for us to estimate the welfare cost that inflation brings to the economy. Then we could acquire the quantity of welfare lost and there will be a measurement and benchmark for governors to use when they make economic policy decisions.First, the dissertation reviews the past literatures. The literatures were classified into: (1) Consumer Surplus Theory, (2)Money in Utility Theory,(3)Cash in Advance Theory,(4)Shopping Time Theory and (5) Search Theory. Relating literatures which was developed by the domestic economists was introduced at last.Three kinds of model were structured based on works of Bailey (1956) ,Cooley & Hansen(1989),Lucas(2000), and Simonsen&Cysne(2001). With the three model -Welfare Triangle Model, Money in Utility Model(MIU) and Shopping Time Model, applying Chinese data, we acquired the welfare cost of inflation for Chinese economy , respectively.The result from Welfare Triangle Model: the welfare cost of inflation when nominal interest rate rises to 10% from 0 is 3.4% of GDP if the money demand was semi-log style, and the value is 3.9% of GDP if the money demand was log-log style. In the analysis, we find when interest rate is in this level, the two cost was similar, but the difference is big when interest rate was very low, where the welfare cost from semi-log is much less than log-log. In addition, at the low interest rate level, the welfare cost function has a more smooth slope for semi-log style, which means the welfare benefit from deduct inflation was little.In the Money in Utility Model, the welfare cost is 4.46% of GDP if nominal interest rate rises to 10% from 0. We find that there is no big difference between the result from MIU and Welfare Triangle when nominal interest rate is small. The conclusion was similar with Lucas(2000).We got a very small welfare cost from Shopping Time Model. It's only 1.6% of GDP. I didn't find the reason why there was a big difference between the result from Shopping Time Model and the result from other models.The welfare cost of inflation of Chinese economy we estimated in this dissertation is much higher than the result that other western economists got, no matter what kind of model we applied. The welfare cost western economists acquired was in the range of 0.6% to 3%. In my view, the reason for the gap were:(l) the interest rate elasticity of money demand is very low, so private sector hold much money in hand for trade and precaution need;(2) a developing financial market, where investment opportunity was scare, increases the cost that people economize on money holding;(3) nominal interest rate was determined by policy makers and it could not reflect the relation of money demand and money supply.At last, I proposed some piece of advice for policy makers hoping that they could do much better and find the balance between keeping high economy growth and low inflation.