2008): “Optimal Fiscal and Monetary Policy when Money is Essential,” Working Paper

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 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. Taken together, these two findings turn conventional wisdom from traditional Ramsey monetary models on its head. ∗The views expressed here are solely those of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserv