Conventional wisdom is that inflation makes people spend money faster, trying to get rid of it like a “hot potato,” and this is a channel through which inflation affects velocity and welfare. Monetary theory with endogenous search intensity seems ideal for studying this. However, in standard models, inflation is a tax that lowers the surplus from monetary exchange and hence reduces search effort. We replace search intensity with a free entry (participation) decision for buyers—i.e., we focus on the extensive rather than intensive margin—and prove buyers always spend their money faster when inflation increases. We also discuss welfare.

The welfare cost of anticipated inflation is quantified in a matching model of money calibrated to 23 different OECD countries for several sample periods. In most economies, in the common period 1978–1998, a representative agent would give up only a fraction of 1% of consumption to avoid 10% inflation. The welfare cost of inflation varies across countries, from a fraction of 0.1% in Japan, to more than 2% in Australia, reaching 6% with bargaining. The model fits money demand data of several countries poorly, however. The fit generally improves with longer sample periods. The results are fairly robust to variations in choice of calibrated parameters and calibration targets.

Rocheteau, Rupert, and Wright [Scandinavian Journal of Economics 109 (2007), 837–855] show that the relationship between inflation and unemployment can be positive or negative, depending on the primitives of the model. The key features are indivisible labor, nonseparable preferences, and bargaining. Their results are derived only for a special case of bargaining, take-it-or-leave-it offer by buyers. Instead of bargaining, this paper considers competitive search. I show that the results of Rocheteau et al. can be generalized to an environment where both buyers and sellers have nonseparable preferences. In addition, the relationship between inflation and unemployment is robust to allowing free entry by sellers, which cannot be studied in Rocheteau et al. (2007).

A model is constructed in which trading partners are asymmetrically informed about future trading opportunities and spatial and informational frictions limit arbitrage between markets. These frictions create inefficiency relative to a full-information equilibrium, and the extent of this inefficiency is affected by monetary policy. A Friedman rule is optimal under a wide range of circumstances, including ones where segmented markets limit the extent of monetary policy intervention.

I use the monetary version of the neoclassical growth model developed by Aruoba, Waller, and Wright [Journal of Monetary Economics (2011)] to study the properties of the model when there is exogenous growth. I first consider the planner's problem, and then the equilibrium outcome in a monetary economy. I do so by first using proportional bargaining to determine the terms of trade and then considering competitive price taking. I obtain closed-form solutions for all variables along the balanced growth path in all cases. I then derive closed-form solutions for the transition paths under the assumption of full depreciation and, in the monetary economy, a particular nonstationary interest rate policy. The key result is that inflation is damaging to per capita income levels along the balanced growth path and to short-run growth of the economy.

An increase in inflation causes people to hold smaller real balances and to speed up their spending. Virtually all monetary models capture the first—inflation tax—effect. Few capture the second—hot potato—effect. Those that do associate negative welfare consequences with the hot potato effect. Because both the inflation tax and the hot potato effect imply that inflation has negative effects on welfare, an optimal monetary policy is characterized by the Friedman rule. In the model presented here, there is a hot potato effect, but—all else held constant—the hot potato effect has positive consequences for welfare. As a result, a departure from the Friedman rule can be socially desirable.