Inflation, Output and Welfare

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. ∗We are grateful to Randall Wright for his input. We also thank Paul Chen, Patrick Kehoe, Ellen McGrattan, Flavio Menezes, Paulo Monteiro, Graeme Wells and seminar participants at the Australian National University, Indiana University and University of Sydney. Lagos thanks the C.V. Starr Center for Applied Economics at NYU for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System. “In a monetary economy, it is in everyone’s private interest to try to get someone else to hold non-interest-bearing cash and reserves. But someone has to hold it all, so all of these efforts must simply cancel out. All of us spend several hours per year in this effort, and we employ thousands of talented and highly-trained people to help us. These person-hours are simply thrown away, wasted on a task that should not have to be performed at all.” Robert E. Lucas Jr., 2000, Inflation and Welfare.