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Foreign Demand for Domestic Currency and the Optimal Rate of Inflation
Author(s) -
SCHMITTGROHÉ STEPHANIE,
URIBE MARTÍN
Publication year - 2012
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2012.00528.x
Subject(s) - economics , monetary economics , inflation tax , inflation (cosmology) , currency , rest (music) , friedman rule , demand for money , deflation , revenue , exchange rate , interest rate , monetary policy , finance , physics , theoretical physics , medicine , cardiology
We characterize the Ramsey optimal rate of inflation in a model with a foreign demand for domestic currency. In the absence of such demand, the model implies that the Friedman rule—deflation at the real rate of interest—is optimal. We show analytically that in the presence of a foreign demand for domestic currency, this result breaks down. Calibrated versions of the model deliver optimal annual rates of inflation between 2% and 10%. The domestically benevolent government imposes an inflation tax to extract resources from the rest of the world in the form of seignorage revenue.