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Optimal inflation in an open economy with imperfect competition

  • David M. Arseneau

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.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-25.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-25
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  1. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Working Papers 0016, University of Washington, Department of Economics.
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