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The Joint and Several Effects of Liquidity Constraints, Financing Constraints, and Financial Intermediation on the Welfare Cost of Inflation



This paper examines two features of modern economies that are often overlooked when formally considering the welfare costs of inflation. The first is the short-term financing requirements of firms, and the second is the joint roles played by banks in providing valued liquidity services to households and in acting as financial intermediaries. Measured welfare losses of moderate inflation are seen to become quite large when firms finance their working capital expenses by issuing short- term debt, with estimates of those losses ranging to over 450 percent higher than is the case when these financing requirements are ignored. Banks are seen to mitigate substantially the welfare costs of inflation by lessening the distortions in household decisions, and by intermediating a larger share of short-term loans to firms as inflation increases.

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