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Avoiding the inflation tax

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  • Huberto M. Ennis

Abstract

I study the effects of inflation on the purchasing behavior of buyers in an economy where money is essential for certain transactions (as in Lagos and Wright, 2005). A long-standing intuition in this subject is that when inflation increases, agents try to spend their money holdings speedily. The standard framework fails to capture this kind of effect (see Lagos and Rocheteau, 2005). I propose a simple modification of the model that improves it in this dimension. I assume that buyers can rebalance their money holdings only sporadically (i.e., not every period). With this minimal change in the environment, I show that higher inflation induces some buyers to spend their money faster by frontloading their consumption, searching more intensively for transactions, and buying low-quality goods. In this way, the model is able to reproduce distortions in the pattern of transactions that, traditionally, have played an important role in the evaluation of the cost of inflation.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 07-06.

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Date of creation: 2007
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Handle: RePEc:fip:fedrwp:07-06

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Keywords: Inflation (Finance) ; Money;

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References

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  1. Aleksander Berentsen & Gabriele Camera & C hristopher W aller, 2005. "The Distribution Of Money Balances And The Nonneutrality Of Money," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 465-487, 05.
  2. Stephen D. Williamson, 2006. "Search, Limited Participation, And Monetary Policy ," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(1), pages 107-128, 02.
  3. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," Papers 88-05, Rochester, Business - General.
  4. Randall Wright & Guillame Rocheteau, 2003. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," Levine's Bibliography 666156000000000302, UCLA Department of Economics.
  5. Christopher Waller & Guillaume Rocheteau, 2005. "Bargaining in Monetary Economies," 2005 Meeting Papers 55, Society for Economic Dynamics.
  6. Miguel Molico, 2006. "The Distribution Of Money And Prices In Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(3), pages 701-722, 08.
  7. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
  8. Chiu, Jonathan & Molico, Miguel, 2010. "Liquidity, redistribution, and the welfare cost of inflation," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 428-438, May.
  9. Ricardo Lagos & Guillaume Rocheteau, 2004. "Inflation, output, and welfare," Working Paper 0407, Federal Reserve Bank of Cleveland.
  10. Brian Peterson & Shouyong Shi, 2004. "Money, price dispersion and welfare," Economic Theory, Springer, vol. 24(4), pages 907-932, November.
  11. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-41, February.
  12. Alvarez, Fernando & Atkeson, Andrew, 1997. "Money and exchange rates in the Grossman-Weiss-Rotemberg model," Journal of Monetary Economics, Elsevier, vol. 40(3), pages 619-640, December.
  13. Jonathan Chiu, 2005. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," 2005 Meeting Papers 108, Society for Economic Dynamics.
  14. Allen Head & Alok Kumar, 2005. "Price Dispersion, Inflation, And Welfare," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 533-572, 05.
  15. Thomas M. Humphrey, 1993. "The origins of velocity functions," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-18.
  16. Boragan Aruoba, S. & Rocheteau, Guillaume & Waller, Christopher, 2007. "Bargaining and the value of money," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2636-2655, November.
  17. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  18. Jovanovic, Boyan, 1982. "Inflation and Welfare in the Steady State," Journal of Political Economy, University of Chicago Press, vol. 90(3), pages 561-77, June.
  19. Pedro Teles & Ruilin Zhou, 2005. "A stable money demand: Looking for the right monetary aggregate," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 50-63.
  20. Tommasi, Mariano, 1999. "On high inflation and the allocation of resources," Journal of Monetary Economics, Elsevier, vol. 44(3), pages 401-421, December.
  21. Alberto Trejos, 1997. "Incentives to produce quality and the liquidity of money (*)," Economic Theory, Springer, vol. 9(2), pages 355-365.
  22. Li, Victor E, 1995. "The Optimal Taxation of Fiat Money in Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(4), pages 927-42, November.
  23. Rubinstein, Ariel & Wolinsky, Asher, 1987. "Middlemen," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 581-93, August.
  24. Li, Victor E, 1997. "The Efficiency of Monetary Exchange in Search Equilibrium," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 61-72, February.
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Citations

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Cited by:
  1. Ed Nosal & Christopher Waller & Randall Wright, 2010. "Introduction to the macroeconomic dynamics: special issues on money, credit, and liquidity," Working Paper Series WP-2010-14, Federal Reserve Bank of Chicago.
  2. Cordelius Ilgmann, Martin Menner, . "Negative Nominal Interest Rates: History and Current Proposals," Working Papers 201143, Institute of Spatial and Housing Economics, Munster Universitary.
  3. Chiu, Jonathan & Molico, Miguel, 2010. "Liquidity, redistribution, and the welfare cost of inflation," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 428-438, May.
  4. Jonathan Chiu & Miguel Molico, 2011. "Uncertainty, Inflation, and Welfare," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 487-512, October.
  5. Stephen D. Williamson & Randall Wright, 2010. "New Monetarist Economics: methods," Staff Report 442, Federal Reserve Bank of Minneapolis.
  6. Lucy Qian Liu & Liang Wang & Randall Wright, 2009. "“On the ‘Hot Potato Effect’ of Inflation: Intensive versus Extensive Margins”," PIER Working Paper Archive 09-040, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  7. Mei Dong & Janet Hua Jiang, 2011. "Money and Price Posting under Private Information," Working Papers 11-22, Bank of Canada.

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