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The Curse of Inflation

Author

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  • Eyster, Erik
  • Madarász, Kristóf
  • Michaillat, Pascal

Abstract

This paper proposes a model that explains the nonneutrality of money from two well-documented 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 induces lower monopolistic 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: consumers misattribute the higher prices arising from higher money supply to higher markups; the misperception of higher markups angers them and makes their demand for goods more elastic; in response, monopolists reduce their markups, thus stimulating economic activity. Through a similar mechanism, an increase in technology induces higher output but higher monopolistic markups and lower hours worked.

Suggested Citation

  • Eyster, Erik & Madarász, Kristóf & Michaillat, Pascal, 2014. "The Curse of Inflation," CEPR Discussion Papers 10286, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10286
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    Cited by:

    1. Michaillat, Pascal & Saez, Emmanuel, 2014. "An economical business-cycle model," LSE Research Online Documents on Economics 86332, London School of Economics and Political Science, LSE Library.

    More about this item

    Keywords

    cursedness; fairness; markup; nonneutrality of money;

    JEL classification:

    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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