THE WELFARE COST OF INFLATION IN A CASH-IN-ADVANCE ECONOMY WITH COSTLY CREDIT

The paper presents a modification of the Lucas-Stokey (1983) cash-in-advance economy in which the representative consumer decides, based on relative prices, which goods to buy with cash and which with costly credit, An explicit Baumol (1952) condition emerges that guides this consumer choice. Deriving and estimating a closed-form welfare cost function in an example economy, the paper shows that the welfare cost of inflation depends on the margins of substitution. The consumer avoids inflation through costly credit and faces higher welfare costs of inflation than in standard cash-in-advance economies.