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Inflation tax in the lab: a theoretical and experimental study of competitive search equilibrium with inflation

  • Nejat Anbarci

    ()

  • Richard Dutu

    ()

  • Nick Feltovich

    ()

How does the inflation tax impact on buyers’ and sellers’ behaviour? How strong is its effect on aggregate economic activity? To answer, we develop a model of directed search and monetary exchange with inflation. In the model, sellers post prices, which buyers observe before deciding on cash holdings that are costly due to inflation. We derive simple theoretical propositions regarding the effects of inflation in this environment. We then test the model’s predictions with a laboratory experiment that closely implements the theoretical framework. Our main finding confirms that not only is the inflation tax harmful to the economy – with cash holdings, GDP and welfare all falling as inflation rises – but also that its effect is relatively larger at low rates of inflation than at higher rates. For instance, when inflation rises from 0% to 5%, GDP falls by 2.8 percent, an effect 5 to 7 times stronger than when inflation rises from 5% to 30%. Our findings lead us to conclude that the inflation tax is a monetary policy channel of primary importance, even at low inflation rates.

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File URL: http://www.deakin.edu.au/buslaw/aef/workingpapers/papers/2013_3.pdf
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Paper provided by Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance in its series Economics Series with number 2013_3.

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Date of creation: 18 Oct 2013
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Handle: RePEc:dkn:econwp:eco_2013_3
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