Tax smoothing and optimal inflation persistence in RBC monetary models revisited

Abstract

This article re-examines the optimality of tax smoothing and optimal inflation persistence in the context of monetary models with cash constraints where the Friedman rule is not optimal. I consider distortionary taxes on either consumption or labor income. As a consequence of the non-optimality of the Friedman rule, the Ramsey-optimal policy features a tax rate volatility that is orders of magnitude larger than the cornerstone tax-smoothing result of the standard Ramsey literature. The Ramsey results also imply an optimal inflation rate that is much more persistent than the existing results. When all consumption goods are subject to a cash constraint, purposeful tax and interest rate volatilities are used to smooth wedges. Therefore, in contrast to the widely accepted view in the literature that in RBC models wedge smoothing implies tax smoothing, this paper shows that this is not necessarily true. I also discuss the Ramsey problem in the context of the cash-credit goods framework with non-homothetic preferences where neither tax-smoothing nor wedge smoothing result necessarily holds when the Friedman rule ceases to be optimal.