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

We investigate how a positive relation between inflation and capital investment (the Mundell-Tobin effect) affects optimal monetary policy in a framework that combines overlapping generations and new Monetarist models. We find that inflation rates above the Friedman rule are optimal if and only if there is a Mundell-Tobin effect. In the absence of the Mundell-Tobin effect, the Friedman rule is optimal. With a Mundell-Tobin effect, increasing inflation above the Friedman rule leads to a first-order welfare gain from increasing capital investment, and only to a second-order welfare loss from reducing consumption in markets where liquidity matters.