Welfare Cost of Inflation in Production Networks

Speaker: A/Prof Saroj Bhattarai

Affiliation: University of Texas

Location: Room 112, Chamberlain Building (#35), St Lucia Campus

Zoom: https://uqz.zoom.us/j/82603079317

Abstract: We study welfare cost of inflation in a quantitative multi-sector menu cost model with production networks and idiosyncratic firms-specific shocks and provide new insights about both the magnitude and determinants of the welfare cost of inflation. The model features heterogeneity in both the distribution of price changes and input-output linkages across sectors. We show theoretically that welfare cost of inflation is driven by two forces: aggregate misallocation, which is given by Domar-weighted within-sector price dispersion; and menu costs paid by firms to adjust prices. We calibrate the model to 65 U.S. sectors by matching sectoral moments of the price change distribution and the input shares from the input-output table. At 2% inflation, we find that welfare cost of inflation is 4.94 times higher in our calibrated production networks economy compared to a counterfactual one-sector economy, while at 4% inflation, it is 5 times higher. Moreover, in our production networks economy, at 2% inflation, the welfare cost of inflation is 0.12% (in consumption-equivalent units relative to 0% inflation)  and the welfare cost increases by 16 basis points at 4% inflation. In contrast, in the one-sector economy, going from 2% inflation to 4% inflation increases the welfare cost of inflation by only 3.2 basis points. Finally, when going from 2% to 4% inflation, 68.7% of the increase in welfare cost of inflation in our production networks economy is due to menu costs incurred while adjusting prices, and only 31.3% due to an increase in aggregate misallocation that results from within-sector price dispersion.