Optimal Monetary Policy with Missing Markets

David Canning ()

Economica, 1989, vol. 56, issue 224, pages 449-58

Abstract: In real business cycle models with spot markets, agents respond optimally to fluctuations by varying their labor supply. While this is individually optimal, the employment volatility that results is efficient; the inefficiency is due to the lack of forward markets for labor and the consequent inability of the young to insure against future shocks. A real business cycle model is constructed in which an active monetary policy, accommodating past price shocks to prevent the expectation of price reversion, Pareto-dominates a stable moeny stock by stabilizing employment over the cycle. Stable employment approximates the outcome with complete insurance markets; the young would like to sell a fixed volume of labor forward, allowing less risk-averse agents to bear the volatility in the spot labor market. These results undermine the use of the "full information" competitive equilibrium as a benchmark for policy analysis in spot market models. Copyright 1989 by The London School of Economics and Political Science.

Date: 1989
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