Preferences for Fair Prices, Cursed Inferences, and the Nonneutrality of Money

This paper explains the nonneutrality of money from two assumptions: (1) consumers dislike paying prices that exceed some fair markup on firms’ marginal costs; and (2) consumers underinfer marginal costs from available information. After an increase in money supply, consumers underappreciate the increase in nominal marginal costs and hence partially misattribute higher prices to higher markups; they perceive transactions as less fair, which increases the price elasticity of their demand for goods; firms respond by reducing markups; in equilibrium, output increases. By raising perceived markups, increased money supply inflicts a psychological cost on consumers that can offset the benefit of increased output. ∗Erik Eyster: Department of Economics, London School of Economics, Houghton Street, London, WC2A 2AE, UK; email: [email protected]. Kristof Madarasz: Department of Management and STICERD, London School of Economics, Houghton Street, London, WC2A 2AE, UK; email: [email protected]. Pascal Michaillat: Department of Economics and Centre for Macroeconomics, London School of Economics, Houghton Street, London, WC2A 2AE, UK; email: [email protected]. This paper supersedes our earlier paper entitled “The Curse of Inflation”. We thank Daniel Benjamin, Youngsung Chang, Stefano DellaVigna, Xavier Gabaix, Nicola Gennaioli, Mark Gertler, Shachar Kariv, John Leahy, Filip Matejka, Emi Nakamura, Matthew Rabin, Ricardo Reis, Guillaume Rocheteau, David Romer, Klaus Schmidt, Jón Steinsson, Silvana Tenreyro, and numerous seminar participants for helpful discussions and comments. This work was supported by the Economic and Social Research Council [grant number ES/K008641/1].