Increased uncertainty about future monetary conditions is often associated with elections or periods of technological innovation or financial deregulation; it usually leads to a rise in the general level of inflation and is often blamed for rises in interest rates or falls in aggregate demand. In Discussion Paper No. 890, Research Fellow Neil Rankin develops a Keynesian model with nominal wage rigidity to investigate the linkages between future monetary uncertainty and current output and employment. Money wages are fixed one period in advance, labour markets exhibit monopoly competition; and infinitely-lived agents with fully rational expectations engage in full dynamic optimization.

With full wage-price flexibility, `increased uncertainty' about future monetary conditions has no effect on current or future real variables, current nominal variables or welfare, provided it is defined so that the mean of the reciprocal of the money supply remains constant as the spread of its probability distribution increases; the expected real interest rate then remains constant, so agents' decisions are unaffected. If the expected mean growth of the money supply remains constant, however, a rise in uncertainty reduces the nominal interest rate and raises welfare; this arises solely because the real interest rate is convex in future prices, however, and has nothing to do with agents' preferences.

Rankin then introduces wage predetermination to show that increased uncertainty with a plausible specification of preferences will raise the nominal interest rate and reduce current aggregate demand, prices, output and hence welfare. It also induces unions to set higher nominal wages, which raises the `natural' rate of unemployment. He concludes by proposing to extend this framework to the open economy to analyse the macroeconomic effects of financial market integration without imposing perfect substitutability between domestic and foreign assets. It could also be applied to investigate the effects of future fiscal and technological uncertainty or to determine optimal macroeconomic policy explicitly in terms of welfare, for which the explicit microfoundations underpinning this framework would be preferable to the customary ad hoc loss function.

Nominal Rigidity and Monetary Uncertainty
Neil Rankin

Discussion Paper No. 890, February 1994 (IM)