The Cost of Inflation

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.