Credit Markets and the Welfare Costs of Inflation
NBER Working Paper No. 4873
We construct a simple model in which high inflation imposes welfare costs because it affects the ability of the financial sector to screen between high and low cost producers. Consumers search for a low price and inflation reduces the incentives to search, resulting in an increase in the demand of high cost producers. We show that beyond a certain level of inflation there is a switch from a separating equilibrium to a pooling equilibrium, where financial institutions become unable to distinguish among clients. In this pooling equilibrium a larger share of credit is allocated to less efficient firms.
Published: Published as "Welfare Costs of Inflation, Seigniorage, and Financial Innovation", IMF, Vol. 38, no. 4 (1991): 675-704.