Composition of Portfolio and Cost of Inflation

The welfare cost of inflation is explored via a search-theoretic model in which along with non-interest-bearing cash, interest-bearing liquid and illiq-uid assets are available. With inflation, agents are willing to replace higher-return illiquid assets with lower-return liquid assets for consumption purchases. The opportunity cost incurred by this adjustment turns out to have quantitatively significant implications on the cost of inflation. A parameterized version of the model suggests that the cost of 10% inflation with liquid and illiquid interest-bearing assets is almost 3 times larger than that in a cash-only model. This implies that most existing measures of inflation cost with narrow money are sub-stantially underestimated.