Welfare Cost of Inflation in Iran: A DOLS Approach

The purpose of this paper is to study the welfare cost of inflation in Iranian economy by using dynamic models. An increase in inflation rate makes individuals to increase their desired level of real balance which in turn leads to an increase in the transaction cost and a decrease in the resources allocated to production of consumption goods. This issue can be analysed as the welfare cost of inflation. To reach that end, we first estimate the money demand function. The estimation is based on cointegration and dynamic least square model (DOLS). The estimation of money demand function is done with the aim of extracting parameters of income and productivity elasticity, parameter of money demand sensitivity to inflation. This estimation has been carried out by applying both static and dynamic models. In the static model, for an inflation rate of 10 percent, the welfare cost of inflation as a portion of income is 36.5 and for a dynamic model, it is 35.4. The results indicate that the central bank policies which have led to a reduction in the rate of inflation have had sufficiently reduced the welfare costs of inflation and this inflation rate is close to its Friedman-Rule value.