Hotelling Meets Keynes: Aggregate Adjustment with Spatial Competition and Nominal Rigidity

This paper embeds a circular Hotelling model of spatial competition into a new-Keynesian model with staggered price setting. The resulting framework provides microfoundations for a cost-push shock, taking the form of random variations in transportation costs. An increase in transportation costs raises price markups and is contractionary and inflationary. Spatial frictions also have consequences for the propagation of aggregate demand disturbances (including monetary shocks), as they dampen their output effects and amplify their inflationary effects. Empirically, the paper shows that the cost of time spent shopping represents a significant fraction of consumption expenditure, suggesting that spatial frictions broadly defined are a nonnegligible feature of aggregate demand.