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SEARCH, WELFARE, AND THE “HOT POTATO” EFFECT OF INFLATION

Published online by Cambridge University Press:  19 December 2011

Ed Nosal
Ed Nosal*
Affiliation:
Federal Reserve Bank of Chicago
*
Address correspondence to: Ed Nosal, Research Department, Federal Reserve Bank of Chicago, 230 S. La Salle St., Chicago, IL 60604, USA; e-mail: ed.nosal@chi.frb.org.
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Abstract

An increase in inflation causes people to hold smaller real balances and to speed up their spending. Virtually all monetary models capture the first—inflation tax—effect. Few capture the second—hot potato—effect. Those that do associate negative welfare consequences with the hot potato effect. Because both the inflation tax and the hot potato effect imply that inflation has negative effects on welfare, an optimal monetary policy is characterized by the Friedman rule. In the model presented here, there is a hot potato effect, but—all else held constant—the hot potato effect has positive consequences for welfare. As a result, a departure from the Friedman rule can be socially desirable.

Keywords

Hot Potato EffectInflationWelfare
Type
Articles
Information
Macroeconomic Dynamics , Volume 15 , Supplement S2: Money, Credit, and Liquidity: Part 2 , September 2011 , pp. 313 - 326
Copyright
Copyright © Cambridge University Press 2011

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References

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