Welfare Costs of Inflation, Seigniorage, and Financial innovation

IMF Working Papers, January 1, 1991

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This paper examines the welfare effects of mitigating the costs of inflation.
In a simple model where money reduces transaction costs, a fall in the costs of inflation is equivalent to financial innovation.
Financial innovation can be caused by paying interest on deposits, indexing money, or “dollarizing.”
Results indicate that financial innovation raises welfare in low inflation economies while reducing it in high inflation economies, due to the offsetting indirect effect of higher inflation to finance the budget.

A fall in the costs of inflation is equivalent to financial innovation in the model.
Forms of financial innovation considered include:
- paying interest on deposits,
- indexing money,
- “dollarizing.”
Welfare effects:
- Financial innovation raises welfare in low inflation economies.
- Financial innovation reduces welfare in high inflation economies.
Mechanism: the welfare-reducing outcome at high inflation arises because financial innovation has an offsetting indirect effect of higher inflation used to finance the budget.

Adoption of financial innovations (paying interest on deposits, indexing money, dollarization) has differential welfare consequences depending on the inflation environment.
In low inflation environments, financial innovation is welfare-improving.
In high inflation environments, financial innovation can be welfare-reducing because it may lead to higher inflation needed to finance the budget.