This paper examines optimal tax policy in a monetary economy in which money serves as an intermediate good that helps facilitate the conversion of scarce resources into tinal consumption goods by enabling consumers to economize on the costs of transacting. It is shown that in such an environment, even though distorting taxes must be levied for revenue purposes, the optimal tax structure calls for abstaining from inflationary finance and adopting the optimum quantity of money rule.

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 laborleisure 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. r

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When the exchange rate is flexible, and thus responds to market forces, it provides agents with useful information, while when it is fixed (by a feedback rule) it does not. The implications of this asymmetry for the stability of real output under the two regimes is discussed. It is shown that whenever shocks are predominantly of one variety, or when domestic monetary shocks are accompanied by one real shock, a flexible exchange rate does a better job of stabilizing real output than does a fixed exchange rate. These results undermine arguments favoring fixed exchange rates because they 'discipline' monetary policy. In addition, it is demonstrated that managed floating rules and exchange rate feedback rules are irrelevant for the distribution of real output.