Shoe‐leather Costs Reconsidered

Abstract

Lucas has recently suggested that the`shoe-leather' costs of in¯ation may amount to as much as 1% of GNP in the United States when moving to the Friedman optimum. We assess his thesis using empirical evidence for the United Kingdom over the period 1870±1994. We ®nd support for Lucas' proposition -that interest rates should be speci®ed in logs -as a description of money demand dynamics, but not as a steady-state characterisation. Although Lucas' estimates can be corroborated, a semilog interest rate speci®cation implies smaller, though still tangible, welfare gain estimates: for example, 0.22% of GNP in perpetuity when moving from 6% to 2% nominal interest rates.Capturing the welfare costs of in¯ation has, on the whole, proved an elusive task for economists. But perhaps the area of least uncertainty surrounds the socalled`shoe-leather' costs of in¯ation -the increased time and cost of making trips to the bank to replenish money balances whenever in¯ation increases. Since Bailey (1956), it has been customary to measure these`shoe-leather' costs as the trapezoid of unsatis®ed demand beneath a money demand schedule, which is foregone at any non-zero nominal interest rate. There is also a common perception that, so-measured, shoe-leather costs are relatively trivial in macroeconomic terms.Certainly, such a conclusion seems robust at the levels of in¯ation currently prevailing within developed economies. For example, Fischer (1981) and McCallum (1989) both estimate that the shoe-leather bene®t from a 10% point reduction in in¯ation is around 0.3% of GNP. But in today's low-in¯ation environment, a reduction in in¯ation of around 2% points seems more apposite. Using the above calculus, such a reduction would deliver a welfare gain of only around 0.06% of GNP -a small number by most people's reckoning. Indeed, a recent study by Feldstein (1995) concludes that the shoeleather savings from a move from 2% to zero in¯ation could well be negative once the indirect effect on seigniorage revenues is taken into account -a point ®rst raised by Phelps (1973). 1 That academic view chimes with anecdotal evidence. A recent survey by Shiller (1996) posed the question`Why do people dislike in¯ation?' Among the general public, there was no mention of the extra time and cost expended by agents replenishing their money balances at high rates of in¯ation. There was, as you might expect, a greater recognition of these costs among econothe comments of two anonymous referees helped materially improve the paper. Martin Cleaves, Bruce Devile, Siobhan Phillips and Jenny Salvage provided valuable research assistance. Of course, any remaining errors and omissions are ours. The views expressed within are not necessarily those of the Bank of England.1 Feldstein (1995) ®nds much larger distortions from in¯ation arising from the imperfect indexation of the United States tax system -amounting perhaps to as much as 1% of GNP in perpetuity. That leads him to argue strongly for a zero in¯ation target.

The Functional Form Of The Demand For Euro Area M1

“…behaved utility functions (see Chadha, Haldane and Janssen, 1998 nominal interest rate spread. However, it is reasonable to assume that the level of this threshold varies across individuals.…”

“…Rearranging terms in (6), a double log long run money demand very similar to that shown in Chadha, Haldane and Janssen (1998) is obtained: ,…”

“…Just for this reason, as recently highlighted by Lucas (200), the analysis of the demand for narrow money may give important indications on the welfare costs of inflation. In particular, Chadha, Haldane and Janssen (1998) and Lucas (2000) recently stressed that money-holding behaviour is very important to assess the welfare costs of inflation. Moreover, the welfare gains of a move to price stability (measured as the possibility of economising in shoe-leather costs) may be significant even at low levels of interest rates (of inflation).…”

“…Equation (3) identifies a money demand function. Chadha, Haldane and Janssen (1998) showed that if the utility function is well behaved, a double log functional form of money demand arises naturally. It is easy to show that this is also valid in the Holman (1998) context, where monetary instruments are interest bearing.…”

Nominal Rigidities and the Optimal Rate of Inflation

“…In addressing the question of the optimal rate of -anticipated -inflation, the focus has primarily been on the inflation tax on money holdings (see eg Chadka et al (1998) for a recent discussion). According to this argument, welfare considerations calls for a negative rate of inflation to ensure a zero nominal rate of interest.…”