Public Finance and the Optimal Inflation Rate
Introduction In the economic literature, there are three main alternative theories of inﬂation prescribing different optimal policies. Friedman (1977) calls for a negative steadystate inﬂation rate as long as the steady-state real interest rate is positive to equalize the social and private cost of producing money (Friedman rule). Optimal monetary policy analyses based on New Keynesian sticky price models identify the driving force in the adjustment cost of the price of goods for the optimal level of long-run (or trend) inﬂation, which has to be set to zero to eliminate the price dispersion effects or price adjustment costs (e.g., Khan et al., 2003; Schmitt-Grohé and Uribe, 2004a). Finally, Phelps (1973) conjectured that to alleviate the burden of distortionary taxation, it might be optimal for governments to resort to monetary ﬁnancing, driving a wedge between the private and the social cost of money, thereby setting a positive inﬂation rate.
Theoretical Foundations of Macroeconomic Policy: Growth, productivity and public finance