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

We investigate whether the Mundell-Tobin effect affects the optimal monetary policy prescription in a framework that is a combination of overlapping generations and new monetarist models. As is standard in the overlapping generations literature, we find that a constant money stock is welfare-maximizing regardless of other parameters if monetary policy is implemented by taxing the young. In that case, the Friedman rule becomes relatively more costly if the Mundell-Tobin effect is stronger. If monetary policy is implemented by taxing the old, the Friedman rule is optimal in the absence of the Mundell-Tobin effect. With the Mundell-Tobin effect present, the optimal money growth rate is an increasing function of the liquidity of capital, approaching a constant money stock for perfectly liquid capital.