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Policy Discussion Paper, No. PDP 2008-8, November 2008
Search, Welfare and the 'Hot Potato' Effect of Inflation

An increase in inflation will cause people to hold less real balances and may cause them to speed up their spending. Virtually all monetary models capture the first effect. Few capture the second—'hot potato'—effect; and those that do associate negative welfare consequences with it. Since, via the inflation tax and the hot potato effect, inflation has negative effects on welfare, an optimal monetary policy will be characterized by Friedman rule. In the model presented in this paper there is a hot potato effect, but—holding all else constant—the hot potato effect has positive consequences for welfare. As a result, a departure from the Friedman rule will be socially desirable.

Policy discussion papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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