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The Cost of Inflation: A Mechanism Design Approach

I apply mechanism design to quantify the cost of inflation that can be attributed to monetary frictions alone. In an environment with pairwise meetings, the money demand that is consistent with a constrained-efficient allocation takes the form of a continuous correspondence that can fit the data over the period 1900–2006. For such parameterizations, the cost of moderate inflation is zero. This result is robust to different assumptions regarding the observability of money holdings, the introduction of match-specific heterogeneity, and endogeneous participation decisions.

Keywords: Cost of inflation, pairwise trades, optimal mechanism.

JEL Classification: D82, D83, E40, E50.

Suggested citation: Rocheteau, Guillaume, 2011. “The Cost of Inflation: A Mechanism Design Approach,” Federal Reserve Bank of Cleveland, Working Paper no. 11-03.

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