Surprise by Anticipated Inflation

Abstract

This paper proposes a theoretical model with two types of households to explore the distributional effects of inflation, assess the non-neutrality of money; and in return, to provide a guideline for policymakers in setting inflation rate. An impatient borrower who faces a borrowing constraint holds a positive amount of debt in equilibrium while a patient lender engages in consumption smoothing. Hence, inflation affects net worth of borrowers via nominal debt by redistributing resources away from lender, rendering welfare gains for the borrower and losses for the lender; and the structure of borrowing constraint gives rise to non-neutrality of anticipated inflation. The utilitarian welfare gain from generating inflation in a cashless economy is amplified when heterogeneous productivity levels are assumed. Yet, incorporating money demand in the form of money-in-utility model suggests that an inflation tax as an additional distortion reverses the overall positive effect of generating inflation in the cashless economy.JEL Classifications: E31, E37, E41, E52, D63. This paper proposes a theoretical model with two types of households to explore the distributional effects of inflation, assess the non-neutrality of money; and in return, to provide a guideline for policy planners in setting inflation rate. Anticipated inflation is shown to affect the net worth of borrowers via nominal debt by redistributing resources away from lender, rendering welfare gains for the borrower and losses for the lender; and the structure of borrowing constraint gives rise to non-neutrality of anticipated inflation. The utilitarian welfare gain from generating inflation in this setting is depicted to rise when heterogeneous productivity levels are assumed. Yet, incorporating money demand into this theoretical environment suggests that an inflation tax as an additional distortion reverses the overall positive effect of generating inflation. The decision by central banks toward using the inflation rate as an instrument to improve utilitarian welfare relies on the presence of money demand motive, the pro-lender/borrower bias, the relationship between intertemporal elasticity of substitutions and the heterogeneous productivity levels among agents. Furthermore, the contribution of this study is that it illustrates the non-neutral effects of the anticipated inflation in a theoretical model as opposed to the unanticipated inflation in the previous literature; and this non-neutrality of inflation is indicated even in the absence of heterogeneity among households contrary to the existing literature.