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“On the ‘Hot Potato Effect’ of Inflation: Intensive versus Extensive Margins”

  • Lucy Qian Liu

    ()

    (International Monetary Fund, Wash D.C.)

  • Liang Wang

    ()

    (Department of Economics, University of Pennsylvania)

  • Randall Wright

    ()

    (Department of Economics, University of Wisconsin-Madison)

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 endoge- nous 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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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 09-040.

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Length: 42 pages
Date of creation: 04 Nov 2009
Date of revision:
Handle: RePEc:pen:papers:09-040
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  1. 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.
  2. Jonathan Chiu, 2005. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," 2005 Meeting Papers 108, Society for Economic Dynamics.
  3. Huberto M. Ennis, 2009. "Avoiding The Inflation Tax," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(2), pages 607-625, 05.
  4. Peter Rupert & Martin Schindler & Randall Wright, 2000. "Generalized search-theoretic models of monetary exchange," Working Paper 0005, Federal Reserve Bank of Cleveland.
  5. 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.
  6. Nosal, Ed, 2011. "Search, Welfare, And The “Hot Potato” Effect Of Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S2), pages 313-326, September.
  7. Jonathan Chiu & Miguel Molico, 2007. "Liquidity, Redistribution, and the Welfare Cost of Inflation," Working Papers 07-39, Bank of Canada.
  8. 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.
  9. Ricardo Lagos & Randall Wright, 2002. "A unified framework for monetary theory and policy analysis," Working Paper 0211, Federal Reserve Bank of Cleveland.
  10. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  11. 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.
  12. Edward J. Green & Ruilin Zhou, . "A Rudimentary Model of Search with Divisible Money and Prices," Penn CARESS Working Papers 2772f94306e08ef7292945588, Penn Economics Department.
  13. Li, Victor E., 1994. "Inventory accumulation in a search-based monetary economy," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 511-536, December.
  14. Randall Wright & Guillame Rocheteau, 2003. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," Levine's Bibliography 666156000000000302, UCLA Department of Economics.
  15. Shi, Shouyong, 1998. "Search for a Monetary Propagation Mechanism," Journal of Economic Theory, Elsevier, vol. 81(2), pages 314-352, August.
  16. Dong, Mei & Jiang, Janet Hua, 2014. "Money and price posting under private information," Journal of Economic Theory, Elsevier, vol. 150(C), pages 740-777.
  17. Aubhik Khan & Julia Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  18. 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.
  19. 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.
  20. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  21. Berentsen, Aleksander & Molico, Miguel & Wright, Randall, 2002. "Indivisibilities, Lotteries, and Monetary Exchange," Journal of Economic Theory, Elsevier, vol. 107(1), pages 70-94, November.
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