DP18642 Local Determinacy in Incomplete-Markets Models
This paper proposes the first methodology for assessing local determinacy in incomplete markets models. My simple determinacy criterion yields theoretical results and can be verified numerically. It merely requires calculating aggregate marginal propensities to consume (MPC) and aggregate elasticities of asset demand. I find that the policy rules ensuring determinacy can be quite different in incomplete as opposed to complete markets models. My methodology can thus avoid the current (flawed) practice of referring to complete markets results to assess determinacy in incomplete markets models. The main findings are: If bonds are nominal, the economy is always determinate for a constant nominal interest rate or for price level targeting if prices are sufficiently rigid. The model is indeterminate if fiscal policy is too expansionary, requiring a monetary policy response to reestablish determinacy. If bonds are real, whether or not the Taylor principle induces determinacy depends non-linearly on MPCs, the degree of price rigidities and whether interest rates respond to output. I also find the determinacy properties of active and passive fiscal rules (Leeper, 1891) to be different in incomplete and complete markets models. I explain the shortcomings in Kaplan, Nikolakoudis and Violante (2023), which are the reason for their different and thus invalid findings.
