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Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting

  • Kevin D. Sheedy

Financial markets are incomplete, thus for many agents borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating agents' nominal incomes from aggregate real shocks, this policy effectively completes the market by stabilizing the ratio of debt to income. The paper argues that the objective of nominal GDP should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1209.

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Date of creation: May 2013
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Handle: RePEc:cep:cepdps:dp1209
Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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  1. Kevin D. Sheedy, 2014. "Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 48(1 (Spring), pages 301-373.
  2. Alma Cohen & Liran Einav, 2005. "Estimating Risk Preferences from Deductible Choice," NBER Working Papers 11461, National Bureau of Economic Research, Inc.
  3. Roman Sustek & Finn Kydland & Carlos Garriga, 2015. "Mortgages and Monetary Policy," 2015 Meeting Papers 500, Society for Economic Dynamics.
  4. Meade, James E, 1978. "The Meaning of "Internal Balance"," Economic Journal, Royal Economic Society, vol. 88(351), pages 423-35, September.
  5. Robert B. Barsky & F. Thomas Juster & Miles S. Kimball & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, Oxford University Press, vol. 112(2), pages 537-579.
  6. Carlos Garriga & Finn E. Kydland & Roman Šustek, 2013. "Mortgages and monetary policy," LSE Research Online Documents on Economics 58248, London School of Economics and Political Science, LSE Library.
  7. Matthias Doepke & Martin Schneider, 2006. "Inflation and the Redistribution of Nominal Wealth," Journal of Political Economy, University of Chicago Press, vol. 114(6), pages 1069-1097, December.
  8. Cochrane, John H, 1991. "A Simple Test of Consumption Insurance," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 957-76, October.
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