Inflation and Welfare in Models with Trading Frictions∗

We study the effects of inflation in models with various trading frictions. The framework is related to recent search-based monetary theory, in that trade takes place periodically in centralized and decentralized markets, but we consider three alternative mechanisms for price formation: bargaining, price taking, and posting. Both the value of money per transaction and market composition are endogenous, allowing us to characterize intensive and extensive margin effects. In the calibrated model, under posting the cost of inflation is similar to previous estimates, around 1% of consumption. Under bargaining, it is considerably bigger, between 3% and 5%. Under price taking, the cost of inflation depends on parameters, but tends to be between the bargaining and posting models. In some cases, moderate inflation may increase output or welfare. ∗We are grateful to the Central Bank Institute at the Federal Reserve Bank of Cleveland for research support, as well as Ricardo Lagos, S. Boragan Aruoba, Paul Chen and Miquel Faig for their input. Wright thanks the NSF and Rocheteau thanks the Faculty of Economics and Commerce of the ANU for their support.