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The purpose of this paper is to see the effects of including a banking sector in the Lucas (2000) model. As Lucas, we have also used McCallum and Good friend's (1979) “Shopping Time Model (STM)”, in which the fundamental assumption is that consumption requires time spent shopping (or transacting) and transaction time may decrease by holding a greater amount of real balance.
In our model inflation can impose welfare cost by two distorting channels: first, during inflationary period households intend to decrease their non interest-bearing money, in order to reduce the impacts of inflation. Therefore, their benefits from the so-called liquidity services of money to facilitate transactions will be declined. In other words, inflation makes them allocate more resources in transaction time and less in producing consumption goods. To explain the second channel, it should be said, inflation may increase demand for banking services to economize transaction time. Therefore, the scarce resources are transferred to the banking sector. These resources can be considered as a social loss. The reason is, if inflation were lower the resources could be used directly in order to increase consumption goods.
The result of introducing new channel to estimate welfare cost of inflation shows that by extending Lucas model the welfare cost of inflation could be measured more precisely.