The Optimal Rate of Inflation When Capital is Taxed

A simple ‘AK’ model of growth is developed in which consumers hold money to reduce transaction costs associated with their purchases of both consumption and investment goods. The government is constrained to choosing between an income tax and inflation as means of financing its expenditure. As a result, there is no presumption in favor of Friedman’s (1969) rule. Numerical simulations are conducted and generally find a low to moderate welfare maximizing rate of inflation.