Keywords: Optimal monetary policy, Friedman rule, international monetary policy coordination
Abstract: This paper uses a two-country, monetary general equilibrium model with imperfect
competition to study the optimal rate of inflation in an open economy. In contrast with
the closed economy literature, when policy is set non-cooperatively in the open economy,
the optimality of the Friedman rule is not a general result. Monetary authorities face
an incentive to use the inflation tax to gain a "beggar-thy-neighbor" advantage over the
terms of trade. Strategic use of the inflation tax, however, results in coordination failure.
International monetary cooperation helps to mitigate this coordination failure and, as a
result, can lead to more efficient equilibria. Monetary union ensures the maximum gain
from cooperation by restoring the optimality of the global Friedman rule, placing the
world economy at the Pareto frontier.
Full paper (999 KB PDF)
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Last update: June 1, 2004