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RESPONDING TO THE INFLATION TAX

  • Tai-Wei Hu (a1) and Cathy Zhang (a2)
Abstract

We adopt mechanism design to study the effects of inflation on output, trade, and capital accumulation. Our theory captures multiple channels for individuals to respond to inflation: search intensity, market participation, and substitution between money and a higher return asset. We characterize constrained efficient allocations and show inflation has nonmonotonic effects on the frequency of trades (extensive margin) and the total quantity traded (intensive margin). The model features monetary superneutrality for low inflation rates, nonlinearities in trading frequencies, and substitution of money for capital for higher inflation rates. While these effects are difficult to capture in previous models, we show how they are intimately related by all being features of an optimal trading mechanism.

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Corresponding author
Address correspondence to: Cathy Zhang, Department of Economics, Purdue University, 100 South Grant Street, West Lafayette, IN 47907, USA; e-mail: cmzhang@purdue.edu.
Footnotes
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We thank the Editor William Barnett, the Associate Editor, and an anonymous referee for their comments. We also thank Guillaume Rocheteau for feedback, Alejandro Komai for assistance on an earlier version of the paper, and seminar and conference participants at the Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of Chicago, Southwest Search and Matching Workshop (U.C. Riverside), Singapore Search and Matching Workshop (Singapore Management University), and the 2014 Spring Midwest Macro Conference (University of Missouri) for helpful discussions and feedback.

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References
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Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
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