Welfare Improving Nominal Contracts

Henning Bohn and Gary Gorton

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The existence of nominal wage and debt contracts is a puzzle. In a model with strategic complementarities, where imperfectly competitive firms inefficiently underinvest, nominal wage or debt contracts are shown to be preferred to indexed contracts. Nominal contracts are an optimal arrangement between firms and workers because such contracts can improve on the underinvestment equilibrium by implementing Pareto-improving transfers between agents. Moreover, we show that if there are multiple underinvestment equilibria, then monetary policy can have real effects because the monetary authority can choose a money supply rule to coordinate beliefs and, thereby, select the best equilibrium.

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