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Inflation and Welfare with Search and Price Dispersion

  • Liang Wang


    (Department of Economics, University of Hawaii)

This paper studies the effect of inflation on welfare in a monetary economy with price dispersion and consumer search. When facing greater price dispersion with higher inflation, consumers search harder for lower prices, and increased search raises welfare by intensifying market competition. Producers post inefficiently high prices, and this creates a welfare loss. Both mechanisms are affected by the consumer's monetary balance. I develop a general equilibrium model with search frictions to incorporate the interrelationship of money, search, and endogenous price dispersion. Inflation aspects welfare through three channels: the real balance channel, the search channel, and the price posting channel. I calibrate the model to U.S. data and find that the welfare cost of 10% annual inflation is worth 3.23% of consumption; however, if either the real balance or the price posting channel is closed, the welfare cost significantly decreases to less than 0.15% of consumption. The price posting channel amplifies the welfare-diminishing effect of the real balance channel, and the aggregated negative effect exceeds the positive effect due to the search channel. The search cost only generates a negligible welfare loss.

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Paper provided by University of Hawaii at Manoa, Department of Economics in its series Working Papers with number 201113.

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Length: 49 pages
Date of creation: 18 Jul 2011
Date of revision:
Handle: RePEc:hai:wpaper:201113
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  1. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  2. 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.
  3. Ariel Burstein & Christian Hellwig, 2008. "Welfare Costs of Inflation in a Menu Cost Model," 2008 Meeting Papers 1, Society for Economic Dynamics.
  4. Allen Head & Alok Kumar & Beverly Lapham, 2006. "Market Power, Price Adjustment, and Inflation," Working Papers 1089, Queen's University, Department of Economics.
  5. Parsley, David C, 1996. "Inflation and Relative Price Variability in the Short and Long Run: New Evidence from the United States," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 323-41, August.
  6. Aruoba, S. Boragan & Waller, Christopher J. & Wright, Randall, 2011. "Money and capital," Journal of Monetary Economics, Elsevier, vol. 58(2), pages 98-116, March.
  7. María Ángeles Caraballo & Carlos Dabús & Carlos Usabiaga, 2004. "Relative Prices and Inflation: New Evidence from Different Inflationary Contexts," Economic Working Papers at Centro de Estudios Andaluces E2004/71, Centro de Estudios Andaluces.
  8. Mustafa Caglayan & Alpay Filiztekin & Michael T. Rauh, 2006. "Inflation, Price Dispersion, and Market Structure," Working Papers 2006-03, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
  9. Allen Head & Lucy Qian Liu & Guido Menzio & Randall Wright, 2010. "Equilibrium Price Dispersion and Rigidity: A New Monetarist Approach," PIER Working Paper Archive 10-034, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  10. Debelle, Guy & Lamont, Owen, 1997. "Relative Price Variability and Inflation: Evidence from U.S. Cities," Journal of Political Economy, University of Chicago Press, vol. 105(1), pages 132-52, February.
  11. Faig, Miquel & Jerez, Belen, 2005. "A theory of commerce," Journal of Economic Theory, Elsevier, vol. 122(1), pages 60-99, May.
  12. Allen Head & Alok Kumar, 2005. "Price Dispersion, Inflation, 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 533-572, 05.
  13. Richard Dutu & Benoit Julien & Ian King, 2012. "On the Welfare Gains of Price Dispersion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(5), pages 757-786, 08.
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