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The optimality of nominal contracts

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  • Scott Freeman
  • Guido Tabellini

Abstract

Why do we see nominal contracts in the presence of price level risk? To answer this question, this paper studies an overlapping generations model in which the equilibrium contract form is optimal, given the contracts elsewhere in the economy. Nominal contracts turn out to be optimal in the presence of aggregate price level risk under two circumstances. First, if individuals have the same constant degree of relative risk aversion. The reason is that in this case nominal contracts (eventually coupled with equity contracts) lead to optimal risk sharing. Second, nominal contracts can be optimal, even if the first condition is not met, if the repayment of contracts is subject to a binding cash in advance constraint. The reason is that a contingent contract, while reducing purchasing power risk, also increases the cash flow risk. Under a binding cash in advance constraint on the repayment of contracts, this second risk is costly, and it is minimized by a nominal contract. Finally, the paper also identifies some symmetry conditions under which nominal contracts are optimal even in the presence of relative price risk.
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Suggested Citation

  • Scott Freeman & Guido Tabellini, 1991. "The optimality of nominal contracts," Working Papers 9114, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddwp:9114
    Note: Published as: Freeman, Scott and Guido Tabellini (1998), "The Optimality of Nominal Contracts," Economic Theory 11 (3): 545-562.
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    References listed on IDEAS

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    1. Townsend, Robert M, 1989. "Currency and Credit in a Private Information Economy," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1323-1344, December.
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    6. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-220, April.
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    8. Gottfries, N., 1989. "A Model Of Nominal Contracts," Papers 455, Stockholm - International Economic Studies.
    9. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-944, October.
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    Cited by:

    1. Choi, Hyung Sun & Kwon, Ohik & Lee, Manjong, 2016. "Inflation, credit, and indexed unit of account," International Review of Economics & Finance, Elsevier, vol. 41(C), pages 144-154.
    2. James T.E. Chapman & Antoine Martin, 2013. "Rediscounting under Aggregate Risk with Moral Hazard," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 651-674, June.
    3. Michael Kremer & Paras Mehta, 2000. "Globalization and International Public Finance," NBER Working Papers 7575, National Bureau of Economic Research, Inc.
    4. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
    5. Antoine Martin & Cyril Monnet, 2000. "When should labor contracts be nominal?," Working Papers 603, Federal Reserve Bank of Minneapolis.
    6. Vladimir Asriyan, 2014. "Balance sheet recessions with informational and trading frictions," Economics Working Papers 1463, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2018.
    7. Toyofuku, Kenta, 2021. "Unit of account, sovereign debt, and optimal currency area," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 75(C).
    8. Zhiguo He & Arvind Krishnamurthy & Konstantin Milbradt, 2019. "A Model of Safe Asset Determination," American Economic Review, American Economic Association, vol. 109(4), pages 1230-1262, April.
    9. Hajime Tomura, 2021. "Nominal contracts and the payment system," The Japanese Economic Review, Springer, vol. 72(2), pages 185-216, April.
    10. Scott Freeman, 2002. "Payments and Output," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 602-617, July.
    11. Kim, Young Sik & Lee, Manjong, 2017. "Money, unit of account, and nominal rigidity," Economics Letters, Elsevier, vol. 160(C), pages 59-63.

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    More about this item

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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