The optimality of nominal contracts |
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Authors: | Scott Freeman Guido Tabellini |
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Institution: | (1) Department of Economics, University of Texas, Austin, TX 78712, USA, US;(2) Universitá Bocconi and Innocenzo Gasparini Institute for Economic Research, via Salasco 5, I-20136 Milano, ITALY, IT |
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Abstract: | Summary. 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.
Received: March 29, 1996; revised version: February 25, 1997 |
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Keywords: | JEL Classification Numbers: E43 E44 D91 |
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