Welfare Cost of Inflation: The Role of Price Markups and Increasing Returns to Production Specialization

Estimates of the welfare costs of moderate inflation are generally modest or small. This paper, by shedding light on increasing returns to production specialization, obtains a substantial welfare cost of 8% in an endogenous growth model of monopolistic competition with endogenous entry. Analytically, we show that the effect of inflation is aggravated (resp. alleviated) by a price markup if the degree of increasing returns to production specialization is relatively high (resp. low). Accordingly, our quantitative analysis indicates that the welfare cost of inflation exhibits an inverted U-shaped relationship with the price markup. This non-monotone is sharply in contradiction to the conventional notion. Nonetheless, the welfare cost of inflation is unambiguously increasing in the degree of increasing returns to production specialization.