Ed Nosal

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

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.

Liquidity and asset prices in a monetary model with OTC asset markets

We study how asset prices are affected by the amount of liquidity that is available in over-the-counter asset markets where dealers post prices and quantities at which they are willing to buy and sell assets. We find that higher levels of market liquidity lead to higher asset prices and lower bid–ask spreads. Hence, an increase in inflation—which lowers market liquidity—increases asset returns and decreases asset prices. When agents immediate consumption needs are stochastic, asset prices will fluctuate even though asset fundamentals are unchanging. The fluctuations in asset prices reflect the stochastic availability of market liquidity that results from agents changing consumption opportunities.