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.