On the Flexibility of Monetary Policy: The Case of the Optimal Inflation Tax

Abstract

This paper examines optimal monetary policy under uncertainty in a context in which policy makers are able to make credible policy commitments. We study an optimal taxation problem of minimizing the social cost of financing a stochastic and exogenous level of government transfers. Since, in the basic model, the welfare costs of inflation derive only from expected inflation, the optimal monetary policy is highly responsive to the state of nature. In a benchmark case in which all shocks are transitory, the optimal policy calls for loading all the variability of government transfers on the shoulders of the inflation tax.