Optimal Fiscal and Monetary Policy with Distorting Taxes

When the interest rate on government debt is low enough, it becomes possible to roll it over indefinitely, never taxing to retire it, without producing a growing debt to GDP ratio. This has been called a situation with zero "fiscal cost" to debt. But when low interest on debt arises from its providing liquidity services, zero fiscal cost is equivalent to finance through seigniorage. The argument of Milton Friedman's optimal quantity of money suggests that it is optimal to make no use of finance through seigniorage. In a simple perfect foresight equilibrium model with a distorting labor tax and a liquidity premium on government debt, we consider whether, and how much, use of seigniorage is optimal. In the optimal steady state, there is some use of seigniorage, but it is quantitively very small unless government spending absorbs a large fraction of output. But a credible, optimizing government that discounts the future at the same rate as private agents makes heavy use of seigniorage at first, while announcing future labor tax rates that grow over time and future inflation that converges to zero.