Price Dispersion, Inflation, and Welfare
This paper examines the effects of inflation on price dispersion and welfare in a search economy with monetary exchange. In the
model ex ante identical buyers search among prices posted by identical sellers. If the probability that a buyer observes only
one price is strictly between zero and one, then stationary monetary equilibrium necessarily exhibits dispersion of real
prices. If the measure of buyers observing a single price is fixed, both price dispersion and the average real price level are
increasing in the inflation rate. Money creation lowers welfare through the inflation tax, the Friedman rule is optimal (in the
limit), and the welfare costs of deviating from it are larger with price dispersion than they would be if the price distribution were
concentrated at the marginal cost price (as it is if all buyers observe at least two prices). If households choose the number of
prices to observe, then the Friedman rule is not optimal. Rather, up to some point increased inflation will raise welfare by eroding
sellers' market power.