Welfare Cost of Inflation Through Rising Market Power

ABSTRACT We study the welfare cost of inflation through its effect on market power. In a monetary search model with endogenous firm entry, the inflation tax erodes households' real money balances, reducing their purchasing power in frictional goods markets. The resulting decline in demand lowers the profitability of marginal firms, driving them out of the market; fewer competing sellers, in turn, charge higher markups. Cross‐country empirical evidence supports the model's predictions. The amplification through rising market power raises the welfare cost of inflation substantially relative to the standard inflation‐tax benchmark. Our findings suggest that policies promoting firm entry and market competition can serve as an effective tool for mitigating the welfare losses from inflation.