CHAPTER 26 FYI Money and Inflation 681 Evidence on the Welfare Cost of Inflation Robert E Lucas Jr of the University of Chicago recently provided estimates of the welfare cost of inflation in the United States, using data over the period from 1900 to 1994.* In doing so, he assumes an interest elasticity of money demand of *0.5 (as in the Baumol and Tobin model we discussed in Chapter 21) and estimates the welfare cost of inflation using tools from public finance and applied microeconomics Lucas argues that reducing the interest rate from 3% to zero yields a benefit equivalent to an increase in real output of about 0.9% (or nine-tenths of one percent) More recently, however, Apostolos Serletis and Kazem Yavari calculated the welfare cost of inflation for Canada and the United States over the post World War II period (from 1948 to 2001), paying particular attention to the time series properties of the money demand variables and using recent advances in the field of applied econometrics to estimate the interest elasticity of money demand (instead of assuming that it is *0.5 as Lucas did).** Their estimates of the interest rate elasticity are *0.22 for Canada and *0.21 for the United States, much lower than the *0.5 value assumed by Lucas Based on this lower estimate of the interest elasticity of money demand, Serletis and Yavari conclude that the welfare cost of inflation is significantly lower than Lucas reported In particular, for the United States, they find that reducing the interest rate from 3% to zero would yield a benefit equivalent to 0.0018 (less than two-tenths of one percent) of real income This is much smaller than the 0.9% (nine-tenths of one percent) figure obtained by Lucas under the assumption that the interest elasticity of money demand is *0.5 They also find that the welfare cost of inflation is marginally lower in Canada than it is in the United States, suggesting that varieties of monetary policy (such as attempts to stabilize interest rates rather than monetary aggregates, or monetary policy with an explicit rather than an implicit nominal anchor) have insignificant welfare effects on the North American economies This is potentially important in the current debate in Canada of whether a floating currency is the right exchange rate regime or whether Canada should fix the exchange rate against the U.S dollar, as in the 1962 1970 period, or consider a currency union with the United States * Robert E Lucas Jr, Inflation and Welfare, Econometrica 68 (2000): 247 274 ** Apostolos Serletis and Kazem Yavari, The Welfare Cost of Inflation in Canada and the United States, Economics Letters 84 (2004): 199 204 process in the 1980s will be discussed in another application later in this chapter.) Although some economists see the 1980s and 1990s as evidence against the money inflation link, others view this as an unusual period characterized by large fluctuations in interest rates and by rapid financial innovation that made the correct measurement of money far more difficult (see Chapter 3) In their view, this period was an aberration, and the close correspondence of money and inflation is sure to reassert itself However, this has not yet occurred What is the underlying cause of the increased rate of money growth that we see occurring from 1960 to 1980? We have identified two possible sources of inflationary monetary policy: government adherence to a high employment target and