DP602 | The Optimality of Nominal Wage Contracts

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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.