Search Frictions in Good Markets and CPI Inflation

We develop a New Keynesian model to analyze how shifts in consumer preferences toward online retailers affect pricing dynamics and inflation. Our framework incorporates goods market search frictions between retailers and producers, with distinct search efficiencies for online and brick-and-mortar retailers. Since search incurs costs, retailers pass these costs on to consumers, creating a wedge between consumer and producer prices. Our analysis identifies two key channels through which these frictions influence inflation: the composition channel, driven by the reallocation of purchases between retailer types with different search efficiencies, and the arbitrage channel, reflecting changes in market tightness due to shifting demand. Bayesian estimation shows that increased consumer preference for online retail lowers CPI inflation by increasing the share of goods purchased through search-efficient retailers while reducing market tightness in brick-and-mortar retail, thereby narrowing the price wedge.