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State-dependent pricing, inflation, and welfare in search economies

  • Ben R. Craig
  • Guillaume Rocheteau

This paper investigates the welfare effects of inflation in economies with search frictions and menu costs. We first analyze an economy where there is no transaction demand for money balances: Money is a mere unit of account. We determine a condition under which price stability is optimal and a condition under which positive inflation is desirable. We relate these conditions to a standard efficiency condition for search economies. Second, we consider a related economy in which there is a transaction role for money. In the absence of menu costs, the Friedman rule is optimal. In the presence of menu costs, the optimal inflation rate is negative for all our numerical examples. A deviation from the Friedman rule can be optimal depending on the extent of the search externalities.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0504.

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Date of creation: 2005
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Handle: RePEc:fip:fedcwp:0504
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  1. Bester, Helmut, 1994. "Price commitment in search markets," Journal of Economic Behavior & Organization, Elsevier, vol. 25(1), pages 109-120, September.
  2. Robert Lucas & Mike Golosov, 2004. "Menu Costs and Phillips Curves," 2004 Meeting Papers 144, Society for Economic Dynamics.
  3. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 825-860.
  4. Nobuhiro Kiyotaki & Randall Wright, 1989. "A contribution to the pure theory of money," Staff Report 123, Federal Reserve Bank of Minneapolis.
  5. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  6. Mark Bils & Peter J. Klenow, 2002. "Some Evidence on the Importance of Sticky Prices," NBER Working Papers 9069, National Bureau of Economic Research, Inc.
  7. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March.
  8. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  9. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
  10. Allen Head & Alok Kumar, 2004. "Price Dispersion, Inflation and Welfare," NajEcon Working Paper Reviews 122247000000000241, www.najecon.org.
  11. 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.
  12. 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.
  13. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, 2007. "Friedman Meets Hosios: Efficiency in Search Models of Money," Economic Journal, Royal Economic Society, vol. 117(516), pages 174-195, 01.
  14. Huberto M. Ennis, 2004. "Search, money, and inflation under private information," Discussion Paper / Institute for Empirical Macroeconomics 142, Federal Reserve Bank of Minneapolis.
  15. Christopher A. Pissarides, 2000. "Equilibrium Unemployment Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262161877, June.
  16. Ben Craig & Guillaume Rocheteau, 2006. "Inflation and welfare: a search approach," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Jan.
  17. Levy, Daniel, et al, 1997. "The Magnitude of Menu Costs: Direct Evidence from Large U.S. Supermarket Chains," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 791-825, August.
  18. Stephen Williamson, 2004. "Search, Limited Participation, and Monetary Policy," 2004 Meeting Papers 214, Society for Economic Dynamics.
  19. Michael Dotsey & Robert G. King & Alexander L. Wolman, 1999. "State-Dependent Pricing And The General Equilibrium Dynamics Of Money And Output," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 655-690, May.
  20. Peter A. Diamond, 1988. "Search, Sticky Prices, and Inflation," Working papers 509, Massachusetts Institute of Technology (MIT), Department of Economics.
  21. Benabou, Roland, 1992. "Inflation and Efficiency in Search Markets," Review of Economic Studies, Wiley Blackwell, vol. 59(2), pages 299-329, April.
  22. Allen Head & Alok Kumar & Beverly Lapham, 2006. "Market Power, Price Adjustment, and Inflation," Working Papers 1089, Queen's University, Department of Economics.
  23. Andrew C. Caplin & Daniel F. Spulber, 1987. "Menu Costs and the Neutrality of Money," NBER Working Papers 2311, National Bureau of Economic Research, Inc.
  24. Sheshinski, Eytan & Weiss, Yoram, 1977. "Inflation and Costs of Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 44(2), pages 287-303, June.
  25. Diamond, Peter A., 1971. "A model of price adjustment," Journal of Economic Theory, Elsevier, vol. 3(2), pages 156-168, June.
  26. Benabou, Roland, 1988. "Search, Price Setting and Inflation," Review of Economic Studies, Wiley Blackwell, vol. 55(3), pages 353-76, July.
  27. Rotemberg, Julio J, 1983. "Aggregate Consequences of Fixed Costs of Price Adjustment [Sticky Prices and Disequilibrium Adjustment in a Rational Model of the Inflationary Process]," American Economic Review, American Economic Association, vol. 73(3), pages 433-36, June.
  28. Caplin, A. & Leahy, J., 1989. "State-Dependent Pricing And The Dynamics Of Money And Output," Discussion Papers 1989_32, Columbia University, Department of Economics.
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