Some Welfare Effects of Inflation

This paper examines the effects of inflation on the efficiency of the price system, output and welfare, through a model of monopolistic competition with consumer search and (S,s) price setting. Its results have relevance for both search theory and macroeconomics. In particular, it provides a foundation for the conventional wisdom linking higher inflation, through increased price dispersion, to more resources spent on search. It also brings to light some efficiencyimproving effects, as well as others whose impact depends on preferences and market structure. The paper's theoretical analysis and numerical simulations thus deliver a message of caution against simple arguments about the "distortions" caused by inflation. INTRODUCTION "A persistent theme in the inflation literature is that inflation interferes with the efficient allocation of the price system" , as noted by Fischer [1984] . One of the channels through which this distortion may operate is often thought to be an increase in relative price variability and dispersion, leading to both inefficient production decisions and more resources being spent on search. Indeed, there is substantial empirical evidence that higher rates of inflation are associated with increased price variability, both across goods (e.g. Fischer [1981] and the references therein, or Taylor [1981]) and within markets for homogeneous goods (Domberger [1987], Dantziger [1987b]). Several theories, surveyed in Fischer [1981], can potentially account for this correlation. There is, however, no model (nor any empirical study) of the hypothesized link between inflation and the resource cost of search. The aim of this paper is to assess the effects of inflation on price dispersion, search costs, the efficiency of the price system, output and ultimately social welfare, through a rigorous model of monopolistically competititive price setting and consumer search. The model is essentially microtheoretic, but individual strategies can be aggregated (in spite of the absence of a representative agent), generating macroeconomic conclusions. Inflation is understood here in the classical sense, as a uniform and anticipated growth rate of aggregate prices. The relevant question is thus superneutrality, and whether 20% annual inflation is worse or better than 10%, and 10% worse or better than 0%. If higher average inflation also means more volatile inflation, there will be other effects in addition to those identified here. Benabou and Gertner [1988] look at the effects on prices and welfare of unanticipated inflation, i.e. focus on the variance rather than trend of aggregate prices, as in Lucas [1973], Cuckierman [1979] [1983] or Hercowitz [1981]. Interestingly, once agents' ability to acquire information through search is recognized, similar conclusions emerge from the two, otherwise dissimilar, models. Benabou [1988] showed that in a search market where price adjustment is costly, inflation can increase price dispersion, thereby intensifying competition, reducing real prices and increasing welfare (entry equalizes profits to zero). Diamond [1988], using different assumptions about search and price adjustment technologies, obtains similar effects for moderate inflation rates (according to simulations); but as inflation increases further, a worsening of the "thin-market" externality prevails and welfare declines. Both models, however, assume that buyers are identical, so that in equilibrium they never search voluntarily, and have unit demand, so that prices' only allocative role is through entry. They are thus of limited use in analysing the resource cost of search and the impact of inflation on the efficiency of the price