UC Santa Cruz

In this dissertation I empirically quantify some of the costs and benefits of a non-zero level of inflation. On the benefits side, I measure inflation's impact on reducing the probability of the ZLB constraining the central bank’s decisions. Regarding the welfare costs, I focus on how the reduction of money holdings due to inflation can have real costs in terms of consumption, output and employment.

In the first essay, using a Time Varying Parameters Vector Auto Regression (TVP-VAR) framework, I construct an index that measures the probability of the nominal interest rate hitting the ZLB within the next 10 quarters. I show empirically how the probability of reaching the ZLB evolves over time and measure quantitatively how a rise of the inflation target can reduce this probability

In the second essay I find evidence of an asymmetric Taylor rule being in use, that as proposed by Reifschneider and Williams (2002 FOMC), respond more strongly to shocks when interest rates are close to zero. I find that a rule of this kind can have an effect on both the probability of hitting the ZLB, and also the sensitivity of this probability to changes on the inflation target. Therefore, using a linear model to evaluate the benefits - in terms of ZLB probability reduction - of an increase on the inflation target could induce biased results in those two fronts.

In the third essay I quantitatively measure the welfare costs of inflation using a monetary search model augmented in order to include an explicit form of imperfect competition between firms, where the share of the surplus going to the firms is determined endogenously.

Under this framework the welfare cost of inflation is amplified by a feedback loop where a restricted money demand induces a reduction in the number of firms the market can support. This in turn increases the market concentration, reducing the consumer surplus and further decreasing the incentives to hold money.

I find that a significant part of the estimated welfare costs of inflation can be derived by this interaction between money holdings and market concentration.