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The optimality of nominal contracts

  • 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)

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.

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Article provided by Springer & Society for the Advancement of Economic Theory (SAET) in its journal Economic Theory.

Volume (Year): 11 (1998)
Issue (Month): 3 ()
Pages: 545-562

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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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  1. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
  2. 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 919-44, October.
  3. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, vol. 24(1), pages 123-137, July.
  4. Smith, B.D., 1988. "A Model Of Nominal Contracts," RCER Working Papers 149, University of Rochester - Center for Economic Research (RCER).
  5. Gottfries, N., 1989. "A Model Of Nominal Contracts," Papers 455, Stockholm - International Economic Studies.
  6. 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.
  7. Fama, Eugene F., 1983. "Financial intermediation and price level control," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 7-28.
  8. Townsend, Robert M, 1989. "Currency and Credit in a Private Information Economy," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1323-44, December.
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