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Foreign Demand for Domestic Currency and the Optimal Rate of Inflation

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  • Uribe, Martín
  • Schmitt-Grohé, Stephanie

Abstract

More than half of U.S. currency circulates abroad. As a result, much of the seignorage income of the United States is generated outside of its borders. In this paper we characterize the Ramsey-optimal rate of inflation in an economy with a foreign demand for its currency. In the absence of such demand, the model implies that the Friedman rule---deflation at the real rate of interest---maximizes the utility of the representative domestic consumer. We show analytically that once a foreign demand for domestic currency is taken into account, the Friedman rule ceases to be Ramsey optimal. Calibrated versions of the model that match the range of empirical estimates of the size of foreign demand for U.S. currency deliver Ramsey optimal rates of inflation between 2 and 10 percent per year. The domestically benevolent government finds it optimal to impose an inflation tax as a way to extract resources from the rest of the world in the form of seignorage revenue.

Suggested Citation

  • Uribe, Martín & Schmitt-Grohé, Stephanie, 2009. "Foreign Demand for Domestic Currency and the Optimal Rate of Inflation," CEPR Discussion Papers 7549, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:7549
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    References listed on IDEAS

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    1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under sticky prices," Journal of Economic Theory, Elsevier, vol. 114(2), pages 198-230, February.
    2. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Optimal fiscal and monetary policy under imperfect competition," Journal of Macroeconomics, Elsevier, vol. 26(2), pages 183-209, June.
    3. Kenneth Rogoff, 1998. "Blessing or curse? Foreign and underground demand for euro notes," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 13(26), pages 262-303.
    4. Ruth A. Judson & Richard D. Porter, 1996. "The location of U.S. currency: how much is abroad?," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), vol. 82(Oct), pages 883-903, October.
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    Cited by:

    1. Calza Alessandro & Zaghini Andrea, 2011. "Welfare Costs of Inflation and the Circulation of U.S. Currency Abroad," The B.E. Journal of Macroeconomics, De Gruyter, vol. 11(1), pages 1-21, May.
    2. Anthony Diercks, 2016. "The Equity Premium, Long-Run Risk, and Optimal Monetary Policy," 2016 Meeting Papers 207, Society for Economic Dynamics.
    3. Schmitt-Grohé, Stephanie & Uribe, Martín, 2010. "The Optimal Rate of Inflation," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 13, pages 653-722, Elsevier.
    4. Alessandro Calza & Andrea Zaghini, 2016. "Shoe-Leather Costs in the Euro Area and the Foreign Demand for Euro Banknotes," International Journal of Central Banking, International Journal of Central Banking, vol. 12(1), pages 231-246, March.
    5. Marc Dordal-i-Carreras & Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2016. "Infrequent but Long-Lived Zero-Bound Episodes and the Optimal Rate of Inflation," NBER Working Papers 22510, National Bureau of Economic Research, Inc.
    6. Ferry Syarifuddin & Toni Bakhtiar, 2022. "The Macroeconomic Effects of an Interest-Bearing CBDC: A DSGE Model," Mathematics, MDPI, vol. 10(10), pages 1-33, May.
    7. Bernardino Adão, 2019. "Why is price stability a key goal of central banks?," Economic Bulletin and Financial Stability Report Articles and Banco de Portugal Economic Studies, Banco de Portugal, Economics and Research Department.
    8. Wang, Olivier, 2020. "Banks, low interest rates, and monetary policy transmission," Working Paper Series 2492, European Central Bank.
    9. Maria Socorro Gochoco-Bautista, 2009. "Global Crises and Reform of the International Monetary System," UP School of Economics Discussion Papers 200914, University of the Philippines School of Economics.
    10. Mehrab Kiarsi, 2022. "Tax smoothing and optimal inflation persistence in RBC monetary models revisited," Scottish Journal of Political Economy, Scottish Economic Society, vol. 69(5), pages 465-486, November.
    11. Anthony M. Diercks, 2015. "The Equity Premium, Long-Run Risk, & Optimal Monetary Policy," Finance and Economics Discussion Series 2015-87, Board of Governors of the Federal Reserve System (U.S.).
    12. Nurlan Turdaliev, 2019. "Heterogeneity and monetary policy," Journal of Economics, Springer, vol. 128(2), pages 119-145, October.
    13. Zhang, Cathy, 2014. "An information-based theory of international currency," Journal of International Economics, Elsevier, vol. 93(2), pages 286-301.
    14. Carlsson, Mikael & Westermark, Andreas, 2016. "Labor market frictions and optimal steady-state inflation," Journal of Monetary Economics, Elsevier, vol. 78(C), pages 67-79.

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    More about this item

    Keywords

    Foreign demand for currency; Friedman rule; Optimal inflation rate;
    All these keywords.

    JEL classification:

    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money

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