Endogenous skill heterogeneity and inflation Radhika Lahiri a, ⁎, Elisabetta Magnani b a Queensland University of Technology, Australia b University of New South Wales, Australia abstract article info Article history: Accepted 6 May 2012 JEL classification: E5 Keywords: Inflation Welfare costs Human capital This paper examines the implications of ex ante skill heterogeneity for long run inflation. We develop a dy- namic general equilibrium model in which there are two types of labor (skilled and unskilled), two types of capital (human and physical), and money is introduced via a cash in advance constraint on consumption purchases. Skill heterogeneity is characterized in terms of (i) a parameter governing the ease with which the two types of labor can be substituted for each other in production; and (ii) the “productivity” of human capital in the production of skill. The model includes the accumulation of human capital which in turn creates skill heterogeneity among workers through an efficiency wage mechanism. Numerical experiments indicate that there is a range of parameter estimates in which the Friedman Rule may not be op- timal. Furthermore, our quantitative experiments also indicate that there is a range of parameter values in which a greater degree of skill heterogeneity may be associated with a greater preference for inflation. Em- pirically, we also find that the inflation and heterogeneity correlation is positive. © 2012 Elsevier B.V. All rights reserved. 1. Introduction Heterogeneity among agents, in various forms, has had interesting implications for economic growth. The focus of a substantial body of literature has, however, been on heterogeneity in the sense of in- equality of wealth, income, or human capital, and its impact on eco- nomic performance (see for example, Galor and Tsiddon, 1997; Glomm and Ravikumar, 1992, and the survey by Zweimuller, 2000, and references therein). In this paper, we revisit the implications of heterogeneity, and our focus is on the link between heterogeneity and inflation. However, our interest is in another dimension of het- erogeneity—one that is of ex ante form, and intrinsic to a neoclassical growth model with a constant elasticity of substitution production function which includes skilled and unskilled labor as inputs in addi- tion to physical and human capital. Of immediate motivational relevance to our subject of study are two strands of literature. One strand of literature is based on a politico-economic perspective of the inflation–heterogeneity link, and rationalizes a positive, negative or non-monotonic link between inflation and inequality, depending on the framework in question (see, for example, Albanesi, 2007; Bhattacharya et al., 2005; Dolmas et al., 2000, and Lahiri and Ratnasiri, 2010). The second strand of lit- erature emphasizes the link between deep structural (e.g., technolog- ical) parameters and economic growth, and examines in particular the implications of CES production functions for economic growth. (For recent examples of the literature on CES production functions see Turnovsky, 2002, and Klump and Preissler, 2000). This research consequently motivates our shift in focus toward another, previously unexplored dimension of heterogeneity, and its implications for the distortions associated with inflation. Specifically, we study the link between agents' heterogeneity and inflation in the framework of an equilibrium model with ex-ante het- erogeneity of the type studied in Kydland (1984, 1995) and Prasad (1996), with money introduced via a cash-in-advance constraint on the purchases of consumption goods. There are two types of workers in the representative household: skilled and unskilled. In contrast to previous work, we assume that the extent of this skill heterogeneity, as formalized in what follows, is endogenous and depends on the human capital accumulation decision undertaken by the representa- tive household and on the “productivity” of human capital in the pro- duction of skill. The return to human capital accumulation is further driven by changes in parameters which impact on the productivity of the skilled worker. The representative household, which effectively owns the repre- sentative firm, is assumed to internalize the positive impact of human capital accumulation on the productivity of the skilled worker and consequently, on wages. In essence, we are making an “efficiency– wage” argument for the household's internalization of the positive externality created by human capital accumulation. An alternative inter- pretation of this modeling approach would be to think of it as a social planner's problem; the social planner internalizes the externality in order to maximize the representative individual's welfare. The outcomes of the model that we focus on are then also interpretable as political economy outcomes. Economic Modelling 29 (2012) 1745–1756 ⁎ Corresponding author. E-mail address: r.lahiri@qut.edu.au (R. Lahiri). 0264-9993/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2012.05.014 Contents lists available at SciVerse ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod