Visiting Frank P. Ramsey: The Public Finance Concept of Optimal Monetary Policy

Abstract:     
Nowadays monetary economists derive optimal policies by solving a Ramsey problem. In this paper I explore the historical context in which this concept of optimality emerged. This approach developed from two ideas. First, economists characterized inflation as a tax on money holdings in the postwar period. This idea is strongly associated with members of the University of Chicago such as Milton Friedman and Martin Bailey, who brought to monetary economics arguments about economic efficiency. The next step was taken by Edmund Phelps who developed a second-best version of Friedman's argument. Welfare-maximizing monetary policies were then formulated by using concepts and tools from the public finance literature. I discuss how monetary economists not only borrowed tools from public finance but also claimed one of its giants as their own: the Cambridge mathematician Frank Ramsey. In my narrative I first discuss Ramsey's original contribution to optimal taxation; I then analyze the circumstances in which Ramsey was rediscovered in the public finance literature in the late 1960s and early 1970s; finally, I study how monetary economists borrowed tools and heroes from public finance in the 1970s. Here also I ponder the current use of Ramsey optimality in monetary economics.

Number of Pages in PDF File: 67

Keywords: Ramsey problem, optimal monetary policy, Friedman rule, inflation as a tax, Ramsey allocation, Frank Ramsey, Milton Friedman, Edmund Phelps

JEL Classification: E52, B22, B23, E50, E60

working papers series