The Welfare Cost of Inflation and the Regulations of Money Substitutes

This paper studies the possibility of using financial regulation that prohibits the use of money substitutes as a tool for mitigating the adverse effects of deviations from the Friedman rule. When inflation is not too high regulation aimed at eliminating money substitutes improves welfare by economizing on transaction costs. The gains from regulation depend on the distribution of income and the level of direct taxation. The area under the demand for money curve is equal to the welfare cost of inflation only when there are no direct taxes and no proportional intermediation cost: otherwise, the area under the demand curve overstates the welfare cost of inflation when money substitutes are not important and understates the welfare cost when money substitutes are important.