Welfare Implication of Banking in the Heterogeneous Agent Monetary Model
Abstract: This paper examines the distributional and welfare implications of inflation in a microfounded monetary model that incorporates two distinctive features: (1) the individual heterogeneity of money holding and (2) the existence of financial intermediation, namely, the banking sector. The model captures the effects of idiosyncratic consumption shocks and inelastic labor supplies on money holding, as well as how an individual household can borrow and lend money through the banking sector to cope with the idiosyncratic shocks. By incorporating these key features, the model shows important dimensions of the distribution of money holdings across households in the United States, including a large fraction of hand-to-mouth households and right-skewed distribution. After calibrating the model to match the empirical aggregate money demand curve, the welfare cost of inflation is quantitatively computed. This model shows the redistributive effects of inflation and the welfare effects of banking, and the results suggest that the annual welfare cost of 10% inflation is 0.54% of consumption, which is lower than the estimates suggested by other relevant studies.