Inflation tax in the lab: a theoretical and experimental study of competitive search equilibrium with inflation

In this paper we measure the effect of the inflation tax on economic activity and welfare within a controlled setting. To do so, we develop a model of price posting and monetary exchange with inflation and finite populations. The model, which provides a game–theoretic foundation to Rocheteau and Wright (2005)׳s competitive search monetary equilibrium, is used to derive theoretical propositions regarding the effects of inflation in this environment, which we test with a laboratory experiment that closely implements the theoretical framework. We find that the inflation tax is harmful – with cash holdings, production and welfare all falling as inflation rises – and that its effect is relatively larger at low inflation rates than at higher rates. For instance, for inflation rates between 0% and 5%, welfare in the two markets we consider (2[seller]×2[buyer] and 3×2) falls by roughly 1 percent for each percentage–point rise in inflation, compared with 0.4 percent over the range from 5% to 30%. Our findings lead us to conclude that the impact of the inflation tax should not be underestimated, even under low inflation.