October 2006 (New!):  Optimal Monetary and Fiscal Policies in a Search Theoretic Model of Monetary Exchange, joint with Pere Gomis-Porqueras, Working Paper.
Abstract:
We study optimal monetary and fiscal policy in a standard random matching model of pairwise trade. In particular, we extend the Lagos-Wright model and solve the Ramsey problem of finding the production subsidies, sales taxes and seignorage that maximize welfare subject to a balanced budget constraint. We find that there are multiple combinations taxes, subsidies and —sometimes strictly positive- inflation rates that achieve the optimal allocation. The Friedman rule alone is not enough to restore efficiency. Moreover, active fiscal policy can completely eliminate the welfare costs of inflation. Finally, we study costly implementation of fiscal policy. We find that active fiscal policy is optimal even when such costs are as high as the total sales tax revenue. In such a case subsidies are paid with an inflation tax while still achieving the socially optimal level of output.



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