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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. Guillaume Rocheteau & Randall Wright, 2004. "Money in search equilibrium, in competitive equilibrium, and in competitive search equilibrium," Working Paper 0405, Federal Reserve Bank of Cleveland.
  2. Aubhik Khan & Julia K. Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  3. Huberto M. Ennis, 2005. "Avoiding the inflation tax," Working Paper 05-10, Federal Reserve Bank of Richmond.
  4. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  5. Peter Rupert & Martin Schindler & Randall Wright, 2000. "Generalized search-theoretic models of monetary exchange," Working Paper 0005, Federal Reserve Bank of Cleveland.
  6. Edward J. Green & Ruilin Zhou, . "A Rudimentary Model of Search with Divisible Money and Prices," Penn CARESS Working Papers 2772f94306e08ef7292945588, Penn Economics Department.
  7. Dale Mortensen, 1984. "Job Search and Labor Market Analysis," Discussion Papers 594, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  8. Mei Dong & Janet Hua Jiang, 2011. "Money and Price Posting under Private Information," Staff Working Papers 11-22, Bank of Canada.
  9. Chiu, Jonathan & Molico, Miguel, 2010. "Liquidity, redistribution, and the welfare cost of inflation," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 428-438, May.
  10. Ricardo Lagos & Guillaume Rocheteau, 2004. "Inflation, output, and welfare," Working Paper 0407, Federal Reserve Bank of Cleveland.
  11. Jonathan Chiu, 2007. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," Staff Working Papers 07-46, Bank of Canada.
  12. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
  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. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  15. 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.
  16. 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.
  17. Berentsen, Aleksander & Molico, Miguel & Wright, Randall, 2002. "Indivisibilities, Lotteries, and Monetary Exchange," MPRA Paper 68582, University Library of Munich, Germany.
  18. Arthur J. Hosios, 1990. "On The Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Oxford University Press, vol. 57(2), pages 279-298.
  19. Shi Shouyong, 1997. "Search for a Monetary Propagation Mechanism," Working Papers 966, Queen's University, Department of Economics.
  20. 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.
  21. Nosal, Ed, 2011. "Search, Welfare, And The “Hot Potato” Effect Of Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S2), pages 313-326, September.
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