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Optimal Inflation Tax And Structural Reform

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Author Info
de V. Cavalcanti, Tiago V.
Villamil, Anne P.

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Abstract

This paper analyzes the optimal inflation tax in economies with structural imperfections in labor, commodity, and currency markets. The Friedman rule is a classic result in economics that claims that the optimal monetary policy is to set a zero nominal interest rate. This Ramsey equilibrium is robust in a wide range of environments without imperfections in input, output, or financial markets. In many developing countries, however, a large fraction of activity takes place in the informal sector. Roughly speaking, the informal sector is the untaxed and unregulated market sometimes referred to as the underground economy. We obtain three results. First, we show that when structural imperfections such as an informal sector exist, the optimal inflation tax is positive. Second, we show that structural imperfections introduce an important asymmetry in the welfare cost function. Third, we provide quantitative results.

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File URL: http://journals.cambridge.org/abstract_S1365100502020096
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Publisher Info
Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 7 (2003)
Issue (Month): 03 (June)
Pages: 333-362
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Handle: RePEc:cup:macdyn:v:7:y:2003:i:03:p:333-362_02

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  1. Pinar Ayse Yesin, 2006. "Financing Government Expenditures Optimally," Working Papers 06.01, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
  2. Alexandre B. Cunha, 2005. "The Optimality of the Friedman Rule When Some Distorting Taxes Are Exogenous," IBMEC RJ Economics Discussion Papers 2005-06, Economics Research Group, IBMEC Business School - Rio de Janeiro. [Downloadable!]
    Other versions:
  3. Stacey Schreft & Bruce Smith, 2008. "The social value of risk-free government debt," Annals of Finance, Springer, vol. 4(2), pages 131-155, March. [Downloadable!] (restricted)
    Other versions:
  4. Robert R. Reed & Stacey L. Schreft, 2007. "Phillips curves, monetary policy, and a labor market transmission mechanism," Research Working Paper RWP 07-12, Federal Reserve Bank of Kansas City. [Downloadable!]
  5. Pinar Yesin, 2004. "Tax Collection Costs, Tax Evasion and Optimal Interest Rates," Working Papers 04.02, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
  6. Stanley Black & Charis Christofides & Alex Mourmouras, 2006. "Convertibility risk: the precautionary demand for foreign currency in a crisis," Annals of Finance, Springer, vol. 2(2), pages 141-165, March. [Downloadable!] (restricted)
  7. Alexandre Cunha, 2004. "The Friedman Rule in a Two Sector Small Open Economy," Econometric Society 2004 North American Summer Meetings 530, Econometric Society. [Downloadable!]
  8. Ahiabu, Stephen, 2006. "Inflation and the underground economy," MPRA Paper 763, University Library of Munich, Germany, revised Nov 2006. [Downloadable!]
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