“Optimal” inflation under dollarization

This paper analyzes the effects of dollarization, where a country (C) uses money produced by another country (M). We derive a general formula to determine the “optimal” rate of inflation, which maximizes M's welfare but does not take into account any loss to C. We show how this inflation varies with relative income size and output growth. Estimates of the “optimal” inflation rate are made for some countries. We also analyze a contract, under which M shares a fraction of total potential seigniorage with C to induce M to inflate at a rate which leads to no seigniorage accruing to M from C. Finally, we provide estimates of the present discounted value of the seigniorage accruing from M to C. Despite this loss, we estimate the net welfare gain to C's household when dollarization results in a lower rate of inflation.