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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. Shi Shouyong, 1997. "Search for a Monetary Propagation Mechanism," Working Papers 966, Queen's University, Department of Economics.
  2. Ricardo Lagos & Guillaume Rocheteau, 2004. "Inflation, output and welfare," Staff Report 342, Federal Reserve Bank of Minneapolis.
  3. 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.
  4. 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.
  5. Jonathan Chiu, 2005. "Endogenously Segmented Asset Market in an Inventory Theoretic Model of Money Demand," 2005 Meeting Papers 108, Society for Economic Dynamics.
  6. Dale Mortensen, 1984. "Job Search and Labor Market Analysis," Discussion Papers 594, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Julia Thomas & Aubhik Khan, 2012. "Inflation and Interest Rates with Endogenous Market Segmentation," 2012 Meeting Papers 1070, Society for Economic Dynamics.
  8. Huberto M. Ennis, 2007. "Avoiding the inflation tax," Working Paper 07-06, Federal Reserve Bank of Richmond.
  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. Edward J. Green & Ruilin Zhou, . ""A Rudimentary Model of Search with Divisible Money and Prices''," CARESS Working Papres 95-17, University of Pennsylvania Center for Analytic Research and Economics in the Social Sciences.
  11. Li, Victor E., 1994. "Inventory accumulation in a search-based monetary economy," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 511-536, December.
  12. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  13. Rupert, Peter & Schindler, Martin & Wright, Randall, 2001. "Generalized search-theoretic models of monetary exchange," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 605-622, December.
  14. Nosal, Ed, 2011. "Search, Welfare, And The “Hot Potato” Effect Of Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S2), pages 313-326, September.
  15. Mei Dong & Janet Hua Jiang, 2011. "Money and Price Posting under Private Information," Working Papers 11-22, Bank of Canada.
  16. 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.
  17. 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.
  18. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  19. 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.
  20. Berentsen, Aleksander & Molico, Miguel & Wright, Randall, 2002. "Indivisibilities, Lotteries, and Monetary Exchange," Journal of Economic Theory, Elsevier, vol. 107(1), pages 70-94, November.
  21. Shouyong Shi, 1996. "A Divisible Search Model of Fiat Money," Working Papers 930, Queen's University, Department of Economics.
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