Abstract
We analyze an economy with taxes and transfers denominated in dollars and an information friction. It is the information friction that allows for volatility in equilibrium prices and allocations. When the price level is expected to be stable, the competitive equilibrium allocation is Pareto optimal. When the price level is volatile, it is not Pareto optimal, but the stable equilibrium allocations do not necessarily dominate the volatile ones. There can be winners and losers from volatility. We identify winners and losers and describe the effect on them of increases in volatility. Our analysis is an application of the weak axiom of revealed preference in the tax-adjusted Edgeworth box.
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