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“On the ‘Hot Potato Effect’ of Inflation: Intensive versus Extensive Margins”

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Author Info

  • Lucy Qian Liu

    ()
    (International Monetary Fund, Wash D.C.)

  • Liang Wang

    ()
    (Department of Economics, University of Pennsylvania)

  • Randall Wright

    ()
    (Department of Economics, University of Wisconsin-Madison)

Abstract

Conventional wisdom is that inflation makes people spend money faster, trying to get rid of it like a “hot potato,” and this is a channel through which inflation affects velocity and welfare. Monetary theory with endoge- nous search intensity seems ideal for studying this. However, in standard models, inflation is a tax that lowers the surplus from monetary exchange and hence reduces search effort. We replace search intensity with a free entry (participation) decision for buyers - i.e., we focus on the extensive rather than intensive margin - and prove buyers always spend their money faster when inflation increases. We also discuss welfare.

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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 09-040.

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Length: 42 pages
Date of creation: 04 Nov 2009
Date of revision:
Handle: RePEc:pen:papers:09-040

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Keywords: Search; Money; Inflation; Velocity; Free Entry;

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References

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  1. Aubhik Khan & Julia Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  2. Mortensen, Dale T., 1987. "Job search and labor market analysis," Handbook of Labor Economics, in: O. Ashenfelter & R. Layard (ed.), Handbook of Labor Economics, edition 1, volume 2, chapter 15, pages 849-919 Elsevier.
  3. 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.
  4. Shi, Shouyong, 1998. "Search for a Monetary Propagation Mechanism," Journal of Economic Theory, Elsevier, vol. 81(2), pages 314-352, August.
  5. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  6. Guillaume Rocheteau & Randall Wright, 2003. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," PIER Working Paper Archive 03-031, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  7. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  8. Ricardo Lagos & Guillaume Rocheteau, 2004. "Inflation, output and welfare," Staff Report 342, Federal Reserve Bank of Minneapolis.
  9. 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.
  10. Huberto M. Ennis, 2007. "Avoiding the inflation tax," Working Paper 07-06, Federal Reserve Bank of Richmond.
  11. 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.
  12. Li, Victor E., 1994. "Inventory accumulation in a search-based monetary economy," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 511-536, December.
  13. Mei Dong & Janet Hua Jiang, 2011. "Money and Price Posting under Private Information," Working Papers 11-22, Bank of Canada.
  14. S. Boragan Aruoba & Christopher J. Waller & Randall Wright, 2009. "Money and capital: a quantitative analysis," Working Papers 2009-031, Federal Reserve Bank of St. Louis.
  15. Berentsen, Aleksander & Molico, Miguel & Wright, Randall, 2002. "Indivisibilities, Lotteries, and Monetary Exchange," Journal of Economic Theory, Elsevier, vol. 107(1), pages 70-94, November.
  16. Edward J. Green & Ruilin Zhou, . "A Rudimentary Model of Search with Divisible Money and Prices," Penn CARESS Working Papers 2772f94306e08ef7292945588, Penn Economics Department.
  17. Rupert, Peter & Schindler, Martin & Wright, Randall, 2001. "Generalized search-theoretic models of monetary exchange," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 605-622, December.
  18. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  19. Jonathan Chiu, 2007. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," Working Papers 07-46, Bank of Canada.
  20. 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.
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Citations

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Cited by:
  1. Stephen D. Williamson & Randall Wright, 2010. "New Monetarist Economics: methods," Staff Report 442, Federal Reserve Bank of Minneapolis.
  2. Ilgmann, Cordelius & Menner, Martin, 2011. "Negative nominal interest rates: History and current proposals," CAWM Discussion Papers 43, Center of Applied Economic Research Münster (CAWM), University of Münster.
  3. Yi Wen, 2012. "Liquidity and welfare," Working Papers 2012-037, Federal Reserve Bank of St. Louis.

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