A new theory of optimal inflation

Central banks like the Bank of England or the Bundesbank have highlighted recently that the supply of currency is achieved not by means of printing and spending but by means of credit. This clarification raises further issues. This article addresses the issue of seigniorage and optimal inflation. So far approaches to seigniorage and optimal inflation are still based on the assumption of a currency which is printed and spend by a central authority. From this perspective central banks’ inflation targets and optimal inflation targets are at odds with those suggested by economic theory. The so-called Friedman-rule, the common core of optimal inflation theory, determines optimal inflation via the (opportunity) cost of producing currency. This basic approach is amended by “external effects”, e.g. the impact of monetary non-neutrality or wage rigidities and so on. However, even under consideration of external effects there remains a significant gap between actual inflation targets and optimal rates as suggested by theory. The supply by means of credit, however, involves “costs of production” which do not appear in Friedman’s case: losses from borrower defaults. Incorporating expected losses into economic theory contributes significantly in aligning central banks’ optima with economic theory and provides a new theory of seigniorage for a credit currency.