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Price Dispersion and the Costs of Inflation

The new Keynesian literature typically makes the assumption that firms always have to satisfy demand. Because this assumption is at odds with profit-maximizing behavior under Calvo pricing when long-run inflation is positive, we present a new Keynesian model that relaxes this assumption. Our model predicts that inflation causes a substantially smaller loss in effective aggregate productivity compared to a benchmark model without the possibility of rationing. Moreover, under positive inflation, firms choose smaller markups over marginal costs in our model than in the benchmark model. As a result, our analysis suggests that the standard new Keynesian model may exaggerate the welfare costs of inflation. We also show that the effects are plausible to be quantitatively important.