Presentation | February 5 | 12-1 p.m. | 639 Evans Hall
Amir Kermani, Assistant Professor, Department of Economics and Haas School of Business
What are the welfare costs of inflation? The evidence to date shows smalls costs of moderate inflation due to two leading explanations: inefficient price dispersion and the inflation tax on liquid assets. In this paper, we argue that the costs of capital misallocation resulting from moderate, low-frequency changes in inflation are in fact orders of magnitude larger than the costs due to the above two explanations. We begin by constructing a novel dataset for more than 50 countries using a variety of sources. We document that for low to medium inflation: (i) housing is a good hedge against inflation risk whereas the stock market is not, (ii) their differential inflation exposure follows from their underlying cash-flows, i.e., rents are highly correlated with inflation whereas corporate profits are not, and (iii) household's portfolios, as well as the composition of aggregate investment, are tilted towards real estate. These results do not vary with the level of a country's financial development and are robust to using food prices as an instrument for aggregate inflation as well as restricting to countries without active monetary policy. Finally, we use this evidence to discipline a canonical model of portfolio choice with Epstein-Zin preferences and IID log-normal returns. We find that the welfare cost of capital misallocation resulting from moderate inflation risk is equivalent to about 0.2 percent reduction in the economys growth rate.
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