The Demand for money, financial innovation, and the welfare cost of inflation: an analysis with household data

We use microeconomic data on households to estimate the parameters
of the demand for currency derived from a generalized Baumol-Tobin
model. Our data set contains information on average currency, deposits,
and other interest-bearing assets; the number of trips to the
bank; the size of withdrawals; and ownership and use of ATM cards.
We model the demand for currency accounting for adoption of new
transaction technologies and the decision to hold interest-bearing
assets. The interest rate and expenditure flow elasticities of the demand
for currency are close to the theoretical values implied by standard
inventory models. However, we find significant differences between
individuals with an ATM card and those without. The estimates of the demand for currency allow us to calculate a measure of the
welfare cost of inflation analogous to Bailey’s triangle, but based on
a rigorous microeconometric framework. The welfare cost of inflation
varies considerably within the population but never turns out to be
very large (about 0.1 percent of consumption or less). Our results are
robust to various changes in the econometric specification. In addition
to the main results based on the average stock of currency, the model
receives further support from the analysis of the number of trips to
and average withdrawals from the bank and the ATM.