Working Paper: CEPR ID: DP602
Authors: Scott Freeman; Guido Tabellini
Abstract: 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, nominal contracts (eventually coupled with equity contracts) lead to optimal risk sharing. Second, nominal contracts can be optimal, even if this condition is not met, if the repayment of contracts is subject to a binding cash-in-advance constraint. The reason for this 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.
Keywords: contingent contracts; money; unit of account; indexing
JEL Codes: E40; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| same constant degree of relative risk aversion (D11) | optimal risk sharing (D63) |
| binding cash-in-advance constraint (E41) | optimality of nominal contracts (D86) |
| cash-in-advance constraint (E41) | cost of cash flow uncertainty (G19) |
| cost of cash flow uncertainty (G19) | optimality of nominal contracts (D86) |