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Thomas F. Cosimano is a Professor of Finance at the Department of Finance, University of Notre Dame, and Michael T. Gapen is an economist in the International Capital Markets Department. The authors wish to thank seminar participants at the IMF, University of Georgia, and United States Naval Academy. Thomas Cosimano received financial support from the Center for Research in Financial Services Industry and the Mendoza College of Business at the University of Notre Dame.
Hereafter refered to as Chari et al.
The superscript “L” is used to denote that the return is indexed, or “linked”, to the price level.
They use the analysis of Abreu, Pearce and Stacchetti (1990) to represent the government policy game as a dynamic programming problem.
The solution was also solved and simulated under discretionary policy. Given that sources of government revenue are distortionary in this economy, optimal policy does not fully inflate away nominal liabilities. This result conforms to that in Lucas and Stokey (1983) which shows that the government has the incentive to inflate away nominal liabilities unless all prices are predetermined or distortionary taxes can be avoided.
Under the discretionary and commitment cases, the first-order condition for money shown here are actually ∂/∂ (exp(−µt+1)). This was done for simplicity of computation. The optimal government policy for money balances can then be found by taking the − log(x) of the result.
The ratio of indexed debt to total debt was calculated as the sum of inflation-indexed notes and bonds relative to to total marketable government debt held by the public.
Additional information regarding implementation of the solution prodecure is available from the authors upon request.
This approach differs from that take in Chari et al. (1994) who begin by fixing the value of the multiplier and iterate across candidate equilibrium solutions. However, the multiplier in their model is the Lagrange multiplier on the implementability constraint in the primal apprach to the Ramsey problem and is not strictly equivalent to the multiplier in this paper.
For example, using data from the U.S. from 1953-1996, Stock and Watson (1999, p. 31) report a standard deviation of 1.61 for total employment hours.
While this result confirms the original conjecture by Bohn (1988), the analysis in this chapter is done in a fully-specified general equilibrium setting.
The idea that the degree of indexation rests on the type and direction of shocks is similar to that found by Gray (1978) in examining optimal indexation and length of wage contracts. In particular, Gray finds that the optimal degree of indexation is positively related to monetary disturbances, but negatively related to real disturbances.