Welfare Costs of Inflation
Paper Session
Saturday, Jan. 4, 2025 10:15 AM - 12:15 PM (PST)
- Chair: Chen Lian, University of California-Berkeley
Who Bears the Costs of Inflation? Euro Area Households and the 2021–2023 Shock
Abstract
We measure the heterogeneous first-order welfare effects of the recent inflation surge across households in the euro area. A simple framework illustrating the numerous transmission channels of surprise inflation to household welfare guides our empirical exercise. By combining micro data and aggregate time series, we conclude that: (i) country-level average welfare costs -- expressed as a share of triennial income -- were sizable and heterogeneous: around 3% in France and Spain, 7% in Germany, and 9% in Italy; (ii) this inflation episode resembles an age-dependent tax, with the retirees losing up to 14%, and roughly half of the 25–44 year-old winning; (iii) losses were quite uniform across consumption quantiles because rigid rents served as a hedge for the poor; (iv) nominal net positions were the key driver of heterogeneity across-households; (v) the rise in energy prices generated vast variation in individual-level inflation rates, but unconventional fiscal policies helped shield households. The counterpart of this household-sector loss is a significant gain for the government.Why Do Workers Dislike Inflation? Wage Erosion and Conflict Costs
Abstract
How costly is inflation to workers? Answers to this question have focused on the path of real wages during inflationary periods. We argue that workers must take costly actions (“conflict”) to have nominal wages catch up with inflation, meaning there are welfare costs even if real wages do not fall as inflation rises. We study a menu-cost style model, where workers choose whether to engage in conflict with employers to secure a wage increase. We show that, following a rise in inflation, wage catch-up resulting from more frequent conflict does not raise welfare. Instead, the impact of inflation on worker welfare is determined by what we term “wage erosion”—how inflation would lower real wages if workers' conflict decisions did not respond to inflation. As a result, measuring welfare using observed wage growth understates the costs of inflation. We conduct a survey showing that workers are willing to sacrifice 1.75% of their wages to avoid conflict. Calibrating the model to the survey data, the aggregate costs of inflation incorporating conflict more than double the costs of inflation via falling real wages alone.The Welfare Cost of Inflation in Production Networks
Abstract
We study the welfare cost of inflation in a multi-sector New Keynesian model with production networks. We derive analytical expressions and sufficient statistics for the cost of inflation and how aggregate productivity and labor supply effects of inflation are determined by the interaction of heterogeneous input-output linkages and price stickiness across sectors. We find that these interactions amplify the costs of inflation by an order of magnitude compared to the standard one-sector New Keynesian model, even at low to moderate levels of inflation. Calibrated to the U.S. economy's input-output structure across 390 sectors, our quantitative model implies consumption-equivalent losses of around 17 basis points at 2% steady-state inflation, which is 16 times larger than what is implied by the standard New Keynesian model. Furthermore, we find that these costs are highly non-linear. For instance, increasing steady-state inflation from 2% to 4% increases the consumption-equivalent losses by 62 basis points, placing the cost of 4% steady state inflation at 79 basis points. Two mechanisms contribute jointly to these significantly higher inflation costs. First, in a network economy, misallocative consequences of inflation are amplified by input-output linkages as they propagate across sectors. Second, the convexity of misallocation in inflation, along with imperfect substitution across sectors, implies that stickier sectors contribute more disproportionately to the cost of inflation.JEL Classifications
- E3 - Prices, Business Fluctuations, and Cycles