Working Paper 05 - 04 May 2005 State - Dependent Pricing , Inflation , and Welfare in Search Economies

Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. This paper investigates the welfare effects of inflation in economies with search frictions and menu costs. We first analyze an economy where there is no transaction demand for money balances: Money is a mere unit of account. We determine a condition under which price stability is optimal and a condition under which positive inflation is desirable. We relate these conditions to a standard efficiency condition for search economies. Second, we consider a related economy in which there is a transaction role for money. In the absence of menu costs, the Friedman rule is optimal. In the presence of menu costs, the optimal inflation rate is negative for all our numerical examples. A deviation from the Friedman rule can be optimal depending on the extent of the search externalities.