Price dispersion, inflation, and welfare

Several empirical studies have documented a positive relationship between the rate of inflation and the dispersion of consumer prices. We examine this relationship and the welfare costs of inflation in a monetary economy in which ex ante identical buyers search among prices posted by identical sellers. Under certain conditions, stationary monetary equilibria of our economy necessarily exhibit dispersion of real prices. If the degree of buyers ’ incomplete information about posted prices is fixed exogenously, both price dispersion and the average real price are increasing in the inflation rate. Money creation lowers welfare by increasing the market power of sellers, exacerbating the effects of the inflation tax. As the rate of inflation approaches the Friedman rule, price dispersion and welfare costs both vanish. If households choose the number of prices to observe, then the Friedman rule is not optimal. Rather, up to some point increased inflation lowers the average real price and raises welfare by inducing search and eroding sellers ’ market power