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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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Technical Working Papers with number 0110.

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Date of creation: Aug 1991
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Handle: RePEc:nbr:nberte:0110

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  1. Smith, Bruce D, 1989. "A Model of Nominal Contracts," Journal of Labor Economics, University of Chicago Press, University of Chicago Press, vol. 7(4), pages 392-414, October.
  2. Townsend, Robert M., 1987. "Asset-return anomalies in a monetary economy," Journal of Economic Theory, Elsevier, Elsevier, vol. 41(2), pages 219-247, April.
  3. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(1), pages 123-137, July.
  4. Townsend, Robert M, 1989. "Currency and Credit in a Private Information Economy," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 97(6), pages 1323-44, December.
  5. Costas Azariadis & Russell Cooper, 1983. "Predetermined Prices and the Allocation of Social Risks," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 660, Cowles Foundation for Research in Economics, Yale University.
  6. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 93(5), pages 919-44, October.
  7. White, Lawrence H, 1984. "Competitive Payments Systems and the Unit of Account," American Economic Review, American Economic Association, American Economic Association, vol. 74(4), pages 699-712, September.
  8. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 18(2), pages 203-20, April.
  9. Fama, Eugene F., 1983. "Financial intermediation and price level control," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(1), pages 7-28.
  10. Gottfries, N., 1989. "A Model Of Nominal Contracts," Papers, Stockholm - International Economic Studies 455, Stockholm - International Economic Studies.
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Cited by:
  1. Antoine Martin & Cyril Monnet, 2001. "When should labor contracts be nominal?," Research Working Paper, Federal Reserve Bank of Kansas City RWP 01-07, Federal Reserve Bank of Kansas City.
  2. James T. E. Chapman & Antoine Martin, 2007. "Rediscounting under aggregate risk with moral hazard," Staff Reports, Federal Reserve Bank of New York 296, Federal Reserve Bank of New York.
  3. Michael Kremer & Paras Mehta, 2000. "Globalization and International Public Finance," NBER Working Papers 7575, National Bureau of Economic Research, Inc.
  4. Scott Freeman, 2002. "Payments and Output," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 602-617, July.

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