Optimal Fiscal and Monetary Policy When Money is Essential

56 Pages Posted: 19 Jan 2007

See all articles by S. Borağan Aruoba

S. Borağan Aruoba

University of Maryland - Department of Economics

Sanjay K. Chugh

University of Maryland

Date Written: September 2006

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.

Keywords: Micro-founded models of money, Friedman Rule, inflation stability

JEL Classification: E13, E52, E62, E63

Suggested Citation

Aruoba, S. Boragan and Chugh, Sanjay K., Optimal Fiscal and Monetary Policy When Money is Essential (September 2006). FRB International Finance Discussion Paper No. 880, Available at SSRN: https://ssrn.com/abstract=958228 or http://dx.doi.org/10.2139/ssrn.958228

S. Boragan Aruoba (Contact Author)

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States
301-405-3508 (Phone)
301-405-3542 (Fax)

Sanjay K. Chugh

University of Maryland ( email )

College Park
College Park, MD 20742
United States

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