Optimal Fiscal and Monetary Policy when Money is Essential

Sanjay Chugh and S. Boragan Aruoba

No 80, 2007 Meeting Papers from Society for Economic Dynamics

Abstract: We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. Our main results are in stark contrast to the prescriptions of earlier flexible-price Ramsey models. Two especially important findings emerge from our work: the Friedman Rule is typically not optimal and inflation is stable over time. Inflation is not a substitute instrument for a missing tax, as is sometimes the case in standard Ramsey models. Rather, the inflation tax is exactly the right tax to use because the use of money has a rent associated with it. Regarding the optimal dynamic policy, realized (ex-post) inflation is quite stable over time, in contrast to the very volatile ex-post inflation rates that arise in standard flexible-price Ramsey models. We also find that because capital is underaccumulated, optimal policy includes a subsidy on capital income. Taken together, these findings turn conventional wisdom from traditional Ramsey monetary models on its head.

Date: 2007
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Related works:
Journal Article: Optimal fiscal and monetary policy when money is essential (2010)
Working Paper: Optimal fiscal and monetary policy when money is essential (2006)
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