Foreign Demand for Domestic Currency and the Optimal Rate of Inflation

Stephanie Schmitt-Grohé, Martín Uribe

NBER Working Paper No. 15494
Issued in November 2009
NBER Program(s):Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

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 annum. 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.

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Document Object Identifier (DOI): 10.3386/w15494

Published: Foreign Demand for Domestic Currency and the Optimal Rate of Inflation (with Martin Uribe), Journal of Money, Credit, and Banking 44, September 2012, 1307-1324.

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