Greasing the Wheels of Trade: Inflation with Menu Costs and Search Frictions

This paper investigates the welfare and output effects of inflation in a monetary economy with search frictions and sticky prices. Agents trade in both a centralized Walrasian market and a decentralized search market. Trade has two dimensions: the frequency of trades (how often agents trade) and the intensity of trades (how much agents produce and consume when a trade occurs). In the centralized market, prices are flexible and clear the market. In the search market, sellers post prices. If prices can be adjusted at no cost, an increase in inflation reduces both the frequency and the intensity of trades, as well as welfare. In the presence of menu costs, inflation can raise both the intensity and the frequency of trades. Furthermore, positive inflation can outperform price stability both in terms of welfare and output. However, the optimal monetary policy calls for deflation.