Revenue maximizing inflation

A classic monetary policy result is that revenue maximization entails setting the inflation tax rate equal to the inverse of the interest semi-elasticity of the demand for money. The standard approach underlying “Cagan's rule” is partial equilibrium in nature, treating money demand as being given from outside the model and abstracting from the real effects of inflation. This paper reconsiders the question of the revenue maximizing inflation rate in a general equilibrium framework with a labor-leisure choice, where money is held because it reduces transactions costs. In this framework, the revenue maximizing inflation tax rate is lower than that implied by Cagan's rule.