Optimal Long-Run Inflation and the Informal Economy

This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government's ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-decreasing function of the size of the informal economy and, in most cases, there is a positive relationship between the two. Finally, substantial deviations from zero inflation are observed even in presence of a plausible degree of price rigidity.