Optimal Inflation in an Open Economy

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