The Curse of Inflation

50 Pages Posted: 8 Dec 2014

See all articles by Erik Eyster

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics

Kristof Madarasz

London School of Economics & Political Science (LSE)

Pascal Michaillat

Brown University - Department of Economics

Date Written: December 2014

Abstract

This paper proposes a model that explains the nonneutrality of money from two well-documented psychological assumptions. The model incorporates into the general-equilibrium monopolistic-competition framework of Blanchard and Kiyotaki [1987] the psychological assumptions that (1) consumers dislike paying a price that exceeds some ``fair'' markup on firms' marginal costs, and (2) consumers do not know firms' marginal costs and fail to infer them from prices. The first assumption in isolation renders the economy more competitive without changing any of its qualitative properties; in particular, money remains neutral. The two assumptions together cause money to be nonneutral: greater money supply induces lower monopolistic markups, higher hours worked, and higher output. Whereas an increase in money supply is expansionary, it decreases the fairness of transactions perceived by consumers to such an extent that it reduces overall welfare. The cost of inflation is a psychological one that derives from a mistaken belief by consumers that transactions have become less fair. In fact, it is this misperception that makes an increase in money supply expansionary: consumers misattribute the higher prices arising from higher money supply to higher markups; the misperception of higher markups angers them and makes their demand for goods more elastic; in response, monopolists reduce their markups, thus stimulating economic activity. Through a similar mechanism, an increase in technology induces higher output but higher monopolistic markups and lower hours worked.

Keywords: cursedness, fairness, markup, nonneutrality of money

JEL Classification: E03, E10, E31

Suggested Citation

Eyster, Erik and Madarasz, Kristof and Michaillat, Pascal, The Curse of Inflation (December 2014). CEPR Discussion Paper No. DP10286, Available at SSRN: https://ssrn.com/abstract=2535423

Erik Eyster (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Kristof Madarasz

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Pascal Michaillat

Brown University - Department of Economics ( email )

64 Waterman Street
Providence, RI 02912
United States

HOME PAGE: http://www.pascalmichaillat.org

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