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The optimality of nominal contracts

  • Scott Freeman
  • Guido Tabellini

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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File URL: http://dallasfed.org/assets/documents/research/papers/1991/wp9114.pdf
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Paper provided by Federal Reserve Bank of Dallas in its series Research Paper with number 9114.

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Date of creation: 1991
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Handle: RePEc:fip:feddrp:9114
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  1. Smith, Bruce D, 1989. "A Model of Nominal Contracts," Journal of Labor Economics, University of Chicago Press, vol. 7(4), pages 392-414, October.
  2. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, vol. 24(1), pages 123-137, July.
  3. 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.
  4. Gottfries, N., 1989. "A Model Of Nominal Contracts," Papers 455, Stockholm - International Economic Studies.
  5. White, Lawrence H, 1984. "Competitive Payments Systems and the Unit of Account," American Economic Review, American Economic Association, vol. 74(4), pages 699-712, September.
  6. Fama, Eugene F., 1983. "Financial intermediation and price level control," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 7-28.
  7. 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.
  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.
  9. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, vol. 18(2), pages 203-20, April.
  10. Townsend, Robert M., 1987. "Asset-return anomalies in a monetary economy," Journal of Economic Theory, Elsevier, vol. 41(2), pages 219-247, April.
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