Working Paper: CEPR ID: DP9843
Authors: Kevin D. Sheedy
Abstract: Financial markets are incomplete, thus for many households borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating households' nominal incomes from aggregate real shocks, this policy effectively completes financial markets by stabilizing the ratio of debt to income. The paper argues the objective of replicating complete financial markets should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.
Keywords: heterogeneous agents; incomplete markets; nominal GDP targeting; risk sharing
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 |
|---|---|
| nominal GDP targeting (E19) | stabilization of household nominal incomes (D19) |
| stabilization of household nominal incomes (D19) | alleviation of risk associated with fixed debt repayments (G32) |
| aggregate real shocks (E19) | households' nominal incomes (D12) |
| nominal GDP targeting (E19) | reduction of adverse consequences of financial market incompleteness (D52) |
| nominal GDP targeting (E19) | completion of financial markets (G10) |
| nominal GDP targeting (E19) | efficient allocation of risk among households (G52) |
| nominal GDP targeting (E19) | clearer nominal anchor (F31) |
| inflation targeting (E31) | inefficiencies caused by incomplete financial markets (D52) |