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Optimal Inflation in an Open Economy

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  • David M. Arseneau

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 -- setting the money growth rate such that the nominal interest rate goes to zero -- is not a general result. An optimizing monetary authority faces 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 a coordination failure that reduces overall welfare. International monetary cooperation helps to mitigate this coordination failure and, as a result, can lead to more efficient equilibria. An institutional arrangement such as a monetary union ensures the maximum gain from cooperation by restoring the optimality of the Friedman rule, placing the world economy at the pareto frontier

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 279.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:279

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Keywords: Optimal Monetary Policy; Friedman Rule; Policy Coordination;

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  1. Russell Cooper & Hubert Kempf, 2003. "Commitment and the Adoption of a Common Currency," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 119-142, February.
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  13. Benigno, Pierpaolo, 2002. "A simple approach to international monetary policy coordination," Journal of International Economics, Elsevier, vol. 57(1), pages 177-196, June.
  14. Canzoneri, Matthew B. & Cumby, Robert E. & Diba, Behzad T., 2005. "The need for international policy coordination: what's old, what's new, what's yet to come?," Journal of International Economics, Elsevier, vol. 66(2), pages 363-384, July.
  15. Kimbrough, Kent P., 1993. "Optimal monetary policies and policy interdependence in the world economy," Journal of International Money and Finance, Elsevier, vol. 12(3), pages 227-248, June.
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  17. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November.
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Cited by:
  1. David Arseneau, 2012. "Expectation traps in a new Keynesian open economy model," Economic Theory, Springer, vol. 49(1), pages 81-112, January.
  2. Cengiz, Gulfer & Cicek, Deniz & Kuzubas, Tolga Umut & Olcay, Nadide Banu & Saglam, Ismail, 2007. "A Monetary Union Model with Cash-in-Advance Constraints," MPRA Paper 4248, University Library of Munich, Germany.

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