Inflation, Output, and Welfare

Abstract

This paper studies the effects of anticipated inflation on aggregate output and welfare within a search-theoretic framework. We allow money-holders to choose the intensities with which they search for trading partners, so inflation affects the frequency of trade as well as the quantity of output produced in each trade. We consider the standard pricing mechanism for search models, i.e. ex-post bargaining, as well as a notion of competitive pricing. If prices are bargained over, the equilibrium is generically inefficient and an increase in inflation reduces buyers' search intensities, output and welfare. If prices are posted and buyers can direct their search, search intensities are increasing with inflation for low inflation rates and decreasing for high inflation rates. The Friedman Rule achieves the first best allocation and inflation always reduces welfare even though it can have a positive effect on output for low inflation rates.

Inflation, Output, and Welfare*

“…In Lagos and Rocheteau (2004) we verify that the main results generalize to the case of an arbitrary bargaining power.…”

“…12 12 In the to Lagos and Rocheteau (2004), we show it is equivalent to define a submarket as a subset of sellers who post the same contract and a subset of buyers who randomly search for individual sellers offering this contract. …”

Inflation tax in the lab: a theoretical and experimental study of competitive search equilibrium with inflation

“…In contrast to Lagos and Wright (2005) who use random matching and bargaining, but similar to Rocheteau and Wright (2005), the Walrasian market is additionally used by our sellers to post prices for the decentralised market, and by each of our buyers to decide which seller to visit in that market. To that extent our model corresponds to a finite-population version of the competitive search monetary equilibrium in Rocheteau and Wright (2005) or Lagos and Rocheteau (2005). 3 Money comes in the form of a perfectly divisible and storable object whose value relies on its use as a medium of exchange.…”

“…Rocheteau and Wright (2005) andLagos and Rocheteau (2005) make several important theoretical points, but those models would be…”

“…Another avenue for future research would examine other channels through which inflation's effects could be felt. For example, the "hot potato effect" (Li, 1994;Lagos and Rocheteau, 2005;Ennis, 2009), by which a rise in inflation induces individuals to get rid of their money holdings faster by speeding up their trades or shopping more intensely, may be well-suited for experimental testing, due to the theoretical possibility that the effect could actually go in the other direction (as noted by Liu, Wang, and Wright (2011)) and the difficulty in finding direct evidence from field data. Still another extension would allow multiple channels through which money can affect the economy (e.g., both the inflation tax and the hot potato effect, or either of these combined with expectations of future macroeconomic variables), thus allowing for direct comparisons between channels.…”