Working Paper: CEPR ID: DP10330
Authors: Csaire A. Meh; Vincenzo Quadrini; Yaz Terajima
Abstract: We study a model with repeated moral hazard where financial contracts are not fully indexed to inflation because nominal prices are observed with delay as in Jovanovic and Ueda 1997. More constrained firms sign contracts that are less indexed to inflation and, as a result, their investment is more sensitive to nominal price shocks. We also find that the overall degree of nominal indexation increases with price uncertainty. An implication of this is that economies with higher inflation uncertainty are less vulnerable to a price shock of a given magnitude. The micro predictions of the model are tested empirically using macro and firm-level data from Canada.
Keywords: inflation uncertainty; nominal indexation; optimal contracts
JEL Codes: E21; E31; E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited nominal indexation in financial contracts (G19) | increased sensitivity of constrained firms' investments to nominal price shocks (H32) |
| increased sensitivity of constrained firms' investments to nominal price shocks (H32) | improvement in net worth of financially constrained entrepreneurs (O16) |
| improvement in net worth of financially constrained entrepreneurs (O16) | facilitates greater investment (F21) |
| facilitates greater investment (F21) | macroeconomic expansion (E69) |
| degree of nominal price indexation increases with inflation uncertainty (E31) | greater degree of nominal indexation (C43) |