On the Welfare Cost of Inflation: The Case of Pakistan

In this paper, we quantify welfare costs of inflation for Pakistan for the period 1960-2007 using semi-log and double-log money demand functions. We find that the welfare gain of moving from positive inflation to zero inflation is approximately the same under both money demand specifications but the behaviour of the two models is fairly different towards low interest rates. Moving from zero inflation to zero nominal interest rate has a substantial gain under double-log form compared to the semi-log function. The compensating variation approach for the semi-log model gives higher welfare loss figures compared to Bailey’s approach. However, the two approaches yield approximately the same welfare cost of inflation for the double-log specification. Keywords: Monetary Policy, Inflation, Interest Rate, Welfare Costs, Money Demand Functions