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Inflation and the underground economy

Ahiabu, Stephen (2006): Inflation and the underground economy.

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Abstract

This paper studies the optimal rate of seigniorage in an economy characterized by bilateral trade and a tax-evading underground sector. Optimal inflation depends on which sector, formal or underground, is more congested with buyers. If the underground sector is more congested, the optimal inflation rate in Peru is about 42.69% per annum. This offers a possible motivation for the high rates of inflation observed in that country in the 1980s. A policy that returns this economy to Friedman rule delivers a welfare loss that is equivalent to a 14% drop in consumption for the representative household. If the formal sector is more congested however, optimal inflation falls to 1.48%, close to the rate observed in 2005.

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