The Curse of Inflation

This paper proposes a model that explains the nonneutrality of money from two welldocumented psychological assumptions. The model incorporates into the general-equilibrium monopolistic-competition framework of Blanchard and Kiyotaki [1987] the psychological assumptions that (1) consumers dislike paying a price that exceeds some “fair” markup on firms’ marginal costs, and (2) consumers do not know firms’ marginal costs and fail to infer them from prices. The first assumption in isolation renders the economy more competitive without changing any of its qualitative properties; in particular, money remains neutral. The two assumptions together cause money to be nonneutral: greater money supply induce higher perceived markups, lower actual markups, higher hours worked, and higher output. Whereas an increase in money supply is expansionary, it decreases the fairness of transactions perceived by consumers to such an extent that it reduces overall welfare. The cost of inflation is a psychological one that derives from a mistaken belief by consumers that transactions have become less fair. In fact, it is this misperception that makes an increase in money supply expansionary. An increase in technology induces higher output and lower perceived markups, but higher actual markups and lower hours worked. ∗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]. We thank Daniel Benjamin, 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, Jon 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].