Inflation and entry costs in a monetary search model

Abstract

In this study, we construct a variant of the Lagos–Wright monetary model in which both buyers and sellers optimally decide whether to enter decentralized market by paying fixed entry costs. In the decentralized market, the sellers produce the intermediate inputs which are necessary to produce the general good traded in the centralized market. We show that the Friedman rule of setting nominal interest rate to zero may not be optimal. The optimal inflation rate is derived explicitly for specific functional forms. It is shown that the optimal inflation rate is lower for lower buyer entry costs, because the lower entry costs generate the buyer’s congestion leading to lower benefit from holding money, which must be balanced by lower cost of money holdings. It is also shown that the optimal inflation is lower for higher seller entry costs.