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A Unified Framework for Monetary Theory and Policy Analysis

Ricardo Lagos
Randall Wright - Consultant

Published September 1, 2004

Search-theoretic models of monetary exchange are based on explicit descriptions of the frictions that make money essential. However, tractable versions of these models typically need strong assumptions that make them ill-suited for studying monetary policy. We propose a framework based on explicit micro foundations within which macro policy can be analyzed. The model is both analytically tractable and amenable to quantitative analysis. We demonstrate this by using it to estimate the welfare cost of inflation. We find much higher costs than the previous literature: our model predicts that going from 10% to 0% inflation can be worth between 3% and 5% of consumption.

Published In: Journal of Political Economy (Vol. 113, No. 3, June 2005, pp. 463-484)

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