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The optimality of nominal contracts

Author

Listed:
  • Guido Tabellini

    (Universit Bocconi and Innocenzo Gasparini Institute for Economic Research, via Salasco 5, I-20136 Milano, ITALY)

  • Scott Freeman

    (Department of Economics, University of Texas, Austin, TX 78712, USA)

Abstract

This paper presents a model in which agents choose to use money as a medium of exchange, a means of payment, and a unit of account. The paper defines conditions under which nominal contracts, promising future payment of a fixed number of units of fiat money, prove to be the optimal contract form in the presence of either relative or aggregate price risk. When relative prices are random, nominal contracts are optimal if individuals have ex ante similar preferences over future consumption. When the aggregate price level is random, whether from shocks to the money supply or aggregate output, nominal contracts (perhaps coupled with equity contracts) lead to optimal risk-sharing if individuals have the same degree of relative risk aversion. Finally, nominal contracts may be optimal if the repayment of contracts is subject to a binding cash-in-advance constraint. In this case, a contingent contract increases the risk of holding excessive cash balances.

Suggested Citation

  • Guido Tabellini & Scott Freeman, 1998. "The optimality of nominal contracts," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 11(3), pages 545-562.
  • Handle: RePEc:spr:joecth:v:11:y:1998:i:3:p:545-562
    Note: Received: March 29, 1996; revised version: February 25, 1997
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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.
    2. Smith, Bruce D, 1989. "A Model of Nominal Contracts," Journal of Labor Economics, University of Chicago Press, vol. 7(4), pages 392-414, October.
    3. Costas Azariadis & Russell Cooper, 1985. "Predetermined Prices and the Allocation of Social Risks," The Quarterly Journal of Economics, Oxford University Press, vol. 100(2), pages 495-518.
    4. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, vol. 24(1), pages 123-137, July.
    5. Gottfries, N., 1989. "A Model Of Nominal Contracts," Papers 455, Stockholm - International Economic Studies.
    6. Fama, Eugene F., 1983. "Financial intermediation and price level control," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 7-28.
    7. 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.
    8. 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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    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. Zhiguo He & Arvind Krishnamurthy & Konstantin Milbradt, 2016. "A Model of Safe Asset Determination," NBER Working Papers 22271, National Bureau of Economic Research, Inc.
    3. 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.
    4. Michael Kremer & Paras Mehta, 2000. "Globalization and International Public Finance," NBER Working Papers 7575, National Bureau of Economic Research, Inc.
    5. Scott Freeman, 2002. "Payments and Output," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 602-617, July.
    6. Vladimir Asriyan, 2015. "Balance sheet recessions with informational and trading frictions," Economics Working Papers 1463, Department of Economics and Business, Universitat Pompeu Fabra, revised Feb 2016.
    7. Antoine Martin & Cyril Monnet, 2000. "When should labor contracts be nominal?," Working Papers 603, Federal Reserve Bank of Minneapolis.
    8. repec:eee:ecolet:v:160:y:2017:i:c:p:59-63 is not listed on IDEAS

    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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