The Cost of Inflation

TL;DR

This paper introduces a production network model showing that inflation can cause significant relative price distortions even with little correlation between inflation rate and price change size, challenging traditional views.

Contribution

It presents a novel network-based model demonstrating how inflation can distort relative prices without affecting overall price change correlations.

Findings

Inflation can cause significant relative price distortions.

The spectral gap, degree distribution, and assortativity influence price distortions.

Empirical evidence aligns with the model's predictions.

Abstract

Empirical evidence suggests that there is little to no correlation between the rate of inflation and the size of price change. Economists have hitherto taken this to mean that monetary shocks do not generate much deviation in relative prices and therefore inflation does not hurt the economy by impeding the workings of the price system. This paper presents a production network model of inflationary dynamics in which it is well possible for inflation to have near-zero correlation with the size of price change yet cause significant distortion of relative prices. The relative price distortion caused by inflation critically depends on the spectral gap, degree distribution, and assortativity of the production network.