Stabilizing, Pareto Improving Policies in an OLG model with Incomplete Markets: The Rational Expectations and Rational Beliefs Case

Carsten Nielsen

No 617, Econometric Society 2004 Far Eastern Meetings from Econometric Society

Abstract: One way to interpret the current policies of many central banks is that they seek to stabilize economic activity. One possible justification for such a policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic 2-period, one agent and one commodity OLG model, where we have added 1 more period, with only one potential activity, namely trading of contingent commodities. We assume, however, that markets are incomplete. In this case the monetary equilibrium is not Pareto Optimal and for an open set of economies an equilibrium where fluctuations in realized savings are removed Pareto dominates the monetary equilibrium. A combination of fiscal and monetary policy may achieve this equilibrium . The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price or interest rate volatility. We consider two fundamental sources of such volatility, namely respectively an objective and a subjective signal about the distribution of future endowments. The first case is when agents have Rational Expectations while the second case is studied in the context of agents having Rational Beliefs, beliefs which are consistent with empirical observations but not (necessarily) correct.}

Keywords: Stabilization; Rational Beliefs; Rational Expectations; Incomplete markets (search for similar items in EconPapers)
JEL-codes: E32 E61 E63 (search for similar items in EconPapers)
Date: 2004-08-11
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