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Stabilizing, Pareto Improving Policies in an OLG model with Incomplete Markets: The Rational Expectations and Rational Beliefs Case

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  • Carsten Krabbe Nielsen

Abstract

One way to interpret the current policies of many central banks is that they seek to stabilize economic activity. One possible justification for such a policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic 2-period, one agent and one commodity OLG model, where we have added 1 more period, with only one potential activity, namely trading of contingent commodities. We assume, however, that markets are incomplete. In this case the monetary equilibrium is not Pareto Optimal and for an open set of economies an equilibrium where fluctuations in realized savings are removed Pareto dominates the monetary equilibrium. A combination of fiscal and monetary policy may achieve this equilibrium . The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price or interest rate volatility. We consider two fundamental sources of such volatility, namely respectively an objective and a subjective signal about the distribution of future endowments. The first case is when agents have Rational Expectations while the second case is studied in the context of agents having Rational Beliefs, beliefs which are consistent with empirical observations but not (necessarily) correct.}

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  • Carsten Krabbe Nielsen, 2004. "Stabilizing, Pareto Improving Policies in an OLG model with Incomplete Markets: The Rational Expectations and Rational Beliefs Case," Econometric Society 2004 Far Eastern Meetings 617, Econometric Society.
  • Handle: RePEc:ecm:feam04:617
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    More about this item

    Keywords

    Stabilization; Rational Beliefs; Rational Expectations; Incomplete markets;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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