“The Optimal Rate of Money Creation in an Overlapping-Generations Model: Numerical Simulations for the U.S. Economy”

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

Abstract

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

This paper examines the optimal rate of money creation in a first-best world. For this purpose, a multiperiod overlapping-generations model is constructed and calibrated for the U.S. economy. The model is first used to find the inflation rate that maximizes welfare in the steady state. Because of the positive relationship between inflation and the capital stock, the steady-state welfare-maximizing inflation rate is not the rate of deflation recommended by Friedman; instead, an annual inflation rate of 3 percent seems to be optimal. However, because a wide range of inflation rates leads to similar welfare outcomes, the paper finds this rate not to be robust. Moreover, it is shown that, when starting from a lower rate of inflation, raising the inflation rate to 3 percent is not a Pareto-efficient policy because the transition to the new steady state leads to a reduction in the welfare of some generations. In other words, the increase in steady-state welfare brought about by the increase in inflation is achieved at the expense of some of the generations alive during the transition to the new steady state.

The issue of the optimal rate of money creation is then re-examined, using an optimality criterion that takes into account the welfare of all generations. The objective of this exercise is to find a Pareto-superior inflation rate such that, starting from any inflation rate, the transition to the new regime imposes no welfare losses on any generation and permits all successive generations to enjoy higher levels of welfare in the new steady state. It turns out that implementing Friedman’s rule is the most efficient policy and that the efficiency gains obtained with such a rule are quite substantial.

Working Paper Summaries (WP/92/1 - WP/92/47)
Author: International Monetary Fund