Monetary Exchange and the Irreducible Cost of Inflation

Abstract: This paper applies a mechanism design approach to construct a lower bound to the welfare cost of inflation that does not depend on quasi-linear preferences or details of how agents trade. An incentive-feasible trading protocol is derived to minimize the welfare loss subject to frictions rendering money essential. The welfare cost of inflation under this optimal protocol is the lower bound over all pairwise trading protocols of monetary exchange. In general, the first-best is not implementable, even under the Friedman's rule, patient agents and the optimal mechanism. Thus, the lower bound depends on fundamentals like preferences and technology. Finally, I estimate the irreducible cost of 10% inflation with the U.S. data from 1900 to 2000.