Liquidity, the Mundell–Tobin Effect, and the Friedman Rule

Abstract

We investigate how the Mundell-Tobin effect, i.e., a positive relation between inflation and capital investment, changes the optimal monetary policy prescription in a framework that combines overlapping generations and new monetarist models. We find that the Friedman rule is optimal if and only if there is no Mundell-Tobin effect. A Mundell-Tobin effect is more likely to occur at the Friedman rule if capital is relatively liquid, and if the agents' risk aversion is relatively low. If the Friedman rule is not optimal, the optimal money growth rate lies between the Friedman rule and a constant money stock. We also show that it is more efficient to implement deflationary monetary policies by raising lump-sum taxes on old agents only.