Price stabilizing, Pareto improving policies

Abstract

One possible justification for a stabilization policy is that there is volatility in macro variables that individual agents cannot insure against. We study the simplest possible extension of the stochastic two-period, one agent and one commodity OLG model, where we have added one 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 allocation where fluctuations in realized savings are removed, Pareto dominates the monetary equilibrium. This allocation may be implemented by means of a monetary/fiscal policy. The policy considered has a simple rationale, namely that it removes some of the uncertainty that agents face by reducing price, i.e 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.