This paper combines two approaches to optimal monetary policy in a unified analytical framework One is the liquidity aspect, which usually deals with the Friedman rule in the context of a long term model, and the other focuses on the motivation to erode the public debt by surprise inflation, which is usually conducted in the framework of a short term model (from the point of view of the individuals). Contrary to the existing literature, we show that it is possible to have a steady state solution of the long term model with positive financial wealth in the discretionary regime, but this requires an extra monetary instrument in addition to base money. For this purpose we use interest on money. We show that the Friedman rule does not hold in the discretionary model when financial wealth is positive. We compare the results of the discretionary regime with an “honest government” model.

The full article in PDF file