Foreign Demand for Domestic Currency and Optimal rate

of inflation

About the following paper

Summarized By: Anoj Ramasamy Sundar (HT094307J)

NBER Working Paper: 15494

Authors: Stephanie Schmitt-Grohe’ and Martin Uribe
Paper title: Foreign Demand for domestic Currency and Optimal Rate of Inflation
USD Published on: November 2009
Circulation
In 2005, $450 billion
of the $760 billion of
US banknotes were Introduction
held in other
countries. More than half of US Currency circulates abroad. As of December 2005, about $450 billion
of the $760 billion of US banknotes were held in other countries.

In absence of a foreign demand for local currency, the welfare maximizing optimal rate of
inflation follows the Friedman rule. Friedman rule is based on the idea that in the long run
inflation is a monetary phenomenon. The opportunity cost of holding money should equal
Friedman’s the social cost of creating additional fiat money. It is assumed that, since the marginal cost
Rule of creating additional money is approximately zero, this opportunity cost; also the nominal

Central bank should rates of interest should be zero.

seek a rate of
deflation equal to Fisher’s rule says:
the real interest Nominal Interest rate = Real Interest Rate + Expected Inflation
rate on government if Nominal Interest Rate is 0,
bonds and other safe Expected inflation = - Real Interest Rate
assets, to make the
nominal interest rate Analytically, this can be shown to be optimal in the absence of foreign demand for
zero.
domestic currency. However, the results are different when there is a substantial foreign
demand. Optimal rates of Inflation have been observed to be anywhere from 2-10%.

In this paper, the authors first present a dynamic monetary model with a foreign demand for
domestic currency, and then establish the optimality and failure of Friedman rule in the
corresponding absence and presence of the foreign demand of domestic currency. They
further go on to show that under plausible conditions, sizable (2-10%) deviation can be
justified from the inflation associated with Friedman’s rule.

1
 The Model and the Dynamic Ramsey Equilibrium
Consider an economy populated by large number of identical households. Each household
has preferences defined over sequences of consumption (ct) and effort (ht) choices in a
time discounted aggregate utility function, over an infinite time horizon.
Money
Velocity
Average frequency
with which a unit of
money is spent in a
specific period of time The single period utility, U is increasing in consumption and decreasing in effort (more
d
work, less leisure), and strictly concave. Nominal money holdings Mt is also the money
supply that facilitates domestic consumption purchases in the economy at any time period.
d
Since money can be reused for transactions, we will also define Money velocity (vt ) and
transaction cost s(vt) that decreases with increasing money velocity.

Households invest in one-period nominal bonds Bt at a nominal interest rate of Rt.

Seignorage
Households supply labor at a real wage rate (wt), and receive profit πt from ownership of
Revenue
firms, and pay income taxes at flat rate of τt. To prevent households from engaging in
Difference between Ponzi-type schemes, a restriction is placed such that in long run, net nominal liabilities grow
interests earned on at a rate smaller than the nominal interest rate. Thus, households cannot roll over their
securities acquired in
debts forever.
exchange for bank
notes and the actual
In this model, Households have to choose sequences of choices {consumption, work hours,
costs of producing
money velocity, Nominal money supply and Bonds} at each time period, given sequences
and distributing those
of {Prices, Taxes, Interest Rates, Profits}
notes

Final good are assumed to be produced by competitive firms using the Technology F(ht) i.e.
only labor as the factor of production. Firms will choose labor input to maximize their profit.

f
Now, let us bring in foreign demand for domestic money (Mt ) and Government actions.
d f
Government prints money (for Domestic Mt and Foreign Mt demand), issues nominal, one-
period bonds and levies taxes to finance an exogenous stream of public consumption gt
and interest obligations on outstanding public debts.

A competitive Ramsey equilibrium is thus a set of sequences of choices {money velocities

–domestic and foreign use, wages, consumption, work hours, domestic and foreign
demand for local money, Bonds issued by govt. and Prices} over an infinite time horizon.

Combining household’s and government’s sequential budget constraints (described above)

also makes it clear that domestic economy collects seignorage revenue from foreigners
whenever nominal balances held
2 by foreigners increase.

2
 Solving the Dynamic Ramsey Problem
The government is assumed to be benevolent towards domestic residents. This means that
welfare function of government coincides with the welfare function of the domestic
households and is independent of the interests and preferences of foreign residents. We fix
the initial price level arbitrarily. Ramsey problem consists in choosing a set of sequences of
{consumption, work hours and money velocity} to maximize household’s utility function
subject to constraints defined in the primal form.
Solving the maximization problem, we can conclude that in case of no foreign demand for
domestic currency, if Ramsey equilibrium exists, it is at zero nominal interest rate.

Failure of Friedman Rule

Without going into the technical aspects of the derivation, let us try to think why, in presence
f
of foreign demand for domestic currency (M > 0), Friedman rule ceases to be Ramsey
optimal. The intuition is based on the fact that at negative inflation (consistent with
Friedman’s rule), foreign money holdings increase in real value as price levels fall, resulting
in welfare transfer from domestic to foreign consumers. Levying a positive inflation to tax
these foreign money holdings, also taxes domestic consumers with a domestic welfare loss
due to increased transaction costs. Thus the Ramsey planner faces this tradeoff of setting an
inflation rate above Friedman’s rule and still maximizing domestic welfare.

Optimal Rate Quantifying Deviation from Friedman’s rule

of Inflation
In absence of Foreign
Demand, follows
Friedman’s rule

In presence of
significant Foreign
demand, is observed
to be 2-10%

Schmitt-Grohe’ and Uribe, developed a numerical algorithm that delivers the exact solutions
to the steady state of Ramsey equilibrium which addresses the planner’s tradeoffs. In this
calibrated model, when foreign demand is nil, inflation is -3.85, income tax rate is 18% and
nominal interest rate is 0, consistent with Friedman’s rule. As foreign demand increases,
Friedman’s rule is no longer optimum. For a foreign demand of 22% of total money, inflation
is 2.1% and nominal interest rate is 6.18%. As foreign demand rises as high as 32%, Inflation
3 targets reach 10.5% with a corresponding reduction in income tax rates.
This optimality solution suggests that benefit from collecting an inflation tax appears to
3 to domestic agents.
strongly dominate inflation costs

3
Conclusion

A significant foreign demand for domestic currency, as seen for the U.S. dollar, can
incentivize monetary authority to generate positive rates of inflation. This acts as a tax to
extract real resources from rest of the world towards domestic consumption. In our model, the
Ramsey planner weights this incentive against the cost that inflation causes to domestic
households. In absence of a foreign demand, Ramsey-optimal policy calls for adopting
Friedman’s rule i.e. deflating at the real rate of interest. For plausible calibrations of our
model, this tradeoff is resolved in favor of taxing foreign holdings of domestic currency at
rates ranging from 2-10% per year

Wor d Co un t

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