In this paper we measure the effect of the inflation tax on economic activity and welfare within a controlled setting. To do so, we develop a model of price posting and monetary exchange with inflation and finite populations. The model, which provides a game-theoretic foundation to Rocheteau and Wright (2005)'s competitive search monetary equilibrium, is used to derive theoretical propositions regarding the effects of inflation in this environment, which we test with a laboratory experiment that closely implements the theoretical framework. We find that the inflation tax is harmful - with cash holdings, production and welfare all falling as inflation rises - and that its effect is relatively larger at low inflation rates than at higher rates. For instance, for inflation rates between 0% to 5%, welfare in the two markets we consider (2[seller]x2[buyer] and 3x2) falls by roughly 1 percent for each percentage-point rise in inflation, compared with 0.4 percent over the range from 5% to 30%. Our findings lead us to conclude that the impact of the inflation tax should not be underestimated, even under low inflation.
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