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OPTIMAL INFLATION TAX AND STRUCTURAL REFORM

Published online by Cambridge University Press:  25 March 2003

Tiago V. de V. Cavalcanti
Affiliation:
Universidade Nova de Lisboa
Anne P. Villamil
Affiliation:
University of Illinois
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Abstract

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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.

Type
Research Article
Copyright
© 2003 Cambridge University Press