Foreign Demand for Domestic Currency and the Optimal Rate of Inflation

19 Pages Posted: 17 Nov 2009 Last revised: 18 Nov 2009

See all articles by Stephanie Schmitt-Grohé

Stephanie Schmitt-Grohé

Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Martín Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: November 2009

Abstract

More than half of U.S. currency circulates abroad. As a result, much of the seignorage income of the United States is generated outside of its borders. In this paper we characterize the Ramsey-optimal rate of inflation in an economy with a foreign demand for its currency. In the absence of such demand, the model implies that the Friedman rule--deflation at the real rate of interest--maximizes the utility of the representative domestic consumer. We show analytically that once a foreign demand for domestic currency is taken into account, the Friedman rule ceases to be Ramsey optimal. Calibrated versions of the model that match the range of empirical estimates of the size of foreign demand for U.S. currency deliver Ramsey optimal rates of inflation between 2 and 10 percent per annum. The domestically benevolent government finds it optimal to impose an inflation tax as a way to extract resources from the rest of the world in the form of seignorage revenue.

Suggested Citation

Schmitt-Grohe, Stephanie and Uribe, Martin, Foreign Demand for Domestic Currency and the Optimal Rate of Inflation (November 2009). NBER Working Paper No. w15494, Available at SSRN: https://ssrn.com/abstract=1505798

Stephanie Schmitt-Grohe (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

National Bureau of Economic Research (NBER)

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Martin Uribe

Columbia University - Graduate School of Arts and Sciences - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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