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Sub-Optimality of the Friedman Rule with Distorting Taxes
André C. Silva
E52 - Monetary Policy (Targets, Instruments, and Effects)
E62 - Fiscal Policy; Public Expenditures, Investment, and Finance; Taxation
E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization
We find that the Friedman rule is not optimal with government transfers and distortionary taxation. This result holds for heterogeneous agents, standard homogeneous preferences, and constant returns to scale production functions. The presence of transfers changes the standard optimal taxation result of uniform taxation. As transfers cannot be taxed, a positive nominal net interest rate is the indirect way to tax the additional income derived from transfers. The higher the transfers, the higher is the optimal inflation rate. We calibrate a model with transfers to the US economy and obtain optimal values for inflation substantially above the Friedman rule.