Working Paper: CEPR ID: DP7549
Authors: Stephanie Schmittgroh; MartÃn Uribe
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 year. 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.
Keywords: foreign demand for currency; friedman rule; optimal inflation rate
JEL Codes: E41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Foreign demand for domestic currency (F31) | Optimal inflation rate (E31) |
| No foreign demand for domestic currency (F31) | Friedman rule optimality (H21) |
| Foreign demand for domestic currency (F31) | Deviation from Friedman rule (E19) |
| Foreign demand for domestic currency (F31) | Necessity for positive inflation rates (E31) |
| Optimal inflation rate (E31) | Trade-off for government between seignorage and transaction costs (E62) |