Avoiding the inflation tax

"This paper is extensively revised from WP 05-10. I study the effects of inflation on the purchasing behavior of buyers in an economy where money is essential for certain transactions (as in Lagos and Wright, 2005). A long-standing intuition in this subject is that when inflation increases, agents try to spend their money holdings speedily. The standard framework fails to capture this kind of effect (see Lagos and Rocheteau, 2005). I propose a simple modification of the model that improves it in this dimension. I assume that buyers can rebalance their money holdings only sporadically (i.e., not every period). With this minimal change in the environment, I show that higher inflation induces some buyers to spend their money faster by frontloading their consumption, searching more intensively for transactions, and buying low-quality goods. In this way, the model is able to reproduce distortions in the pattern of transactions that, traditionally, have played an important role in the evaluation of the cost of inflation."--Federal Reserve Bank of Richmond web site.