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On The “Hot Potato” Effect Of Inflation: Intensive Versus Extensive Margins

  • Liu, Lucy Qian
  • Wang, Liang
  • Wright, Randall

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 endogenous 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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Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 15 (2011)
Issue (Month): S2 (September)
Pages: 191-216

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Handle: RePEc:cup:macdyn:v:15:y:2011:i:s2:p:191-216_00
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  1. Edward J. Green & Ruilin Zhou, . "A Rudimentary Model of Search with Divisible Money and Prices," Penn CARESS Working Papers 2772f94306e08ef7292945588, Penn Economics Department.
  2. Nosal, Ed, 2011. "Search, Welfare, And The “Hot Potato” Effect Of Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S2), pages 313-326, September.
  3. Li, Victor E., 1994. "Inventory accumulation in a search-based monetary economy," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 511-536, December.
  4. Jonathan Chiu & Miguel Molico, 2007. "Liquidity, Redistribution, and the Welfare Cost of Inflation," Staff Working Papers 07-39, Bank of Canada.
  5. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  6. Ricardo Lagos & Guillaume Rocheteau, 2005. "Inflation, Output, 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 495-522, 05.
  7. 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.
  8. Guillaume Rocheteau & Randall Wright, 2005. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 175-202, 01.
  9. Peter Rupert & Martin Schindler & Randall Wright, 2000. "Generalized search-theoretic models of monetary exchange," Working Paper 0005, Federal Reserve Bank of Cleveland.
  10. 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.
  11. Aubhik Khan & Julia K. Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  12. Berentsen, Aleksander & Molico, Miguel & Wright, Randall, 2002. "Indivisibilities, Lotteries, and Monetary Exchange," MPRA Paper 68582, University Library of Munich, Germany.
  13. Jonathan Chiu, 2007. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," Staff Working Papers 07-46, Bank of Canada.
  14. Huberto M. Ennis, 2005. "Avoiding the inflation tax," Working Paper 05-10, Federal Reserve Bank of Richmond.
  15. 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.
  16. Arthur J. Hosios, 1990. "On The Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Oxford University Press, vol. 57(2), pages 279-298.
  17. Mei Dong & Janet Hua Jiang, 2011. "Money and Price Posting under Private Information," Staff Working Papers 11-22, Bank of Canada.
  18. Shi, Shouyong, 1998. "Search for a Monetary Propagation Mechanism," Journal of Economic Theory, Elsevier, vol. 81(2), pages 314-352, August.
  19. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
  20. 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.
  21. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
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