Price level volatility and incomplete financial markets

Money is one of the most important elements in the modern economy, but it has a critical disadvantage; it is vulnerable to inflation and inflation uncertainty, mainly due to unstable monetary policies or market psychology (sunspots). The main focus of this dissertation is to investigate the impact of financial innovation or fiscal policies on welfare and asset prices when the economy is contaminated by inflation volatility. This dissertation consists of four essays.;The first essay investigates an economy with incomplete financial markets as described by Cass (1989), where there is typically a continuum of equilibria driven by sunspots. In this essay, I define price volatility in a natural way and take it as a parameter of a derived economy. I show that for each level of price volatility, there is a unique regular sunspot-economy. Typically, there is no Pareto ranking among the different sunspot economies. However, I consider a compensation test based on balanced lump-sum tax-transfer plans that are implemented in period 0 and denominated in money or commodities. This test reveals that lower volatility economies are generically Kaldor-Hicks superior to higher volatility economies. The findings imply that Kaldor-Hicks efficiency is achieved through sunspot-stabilizing policies.;The second essay introduces a sunspots-economy where both money and inflation-indexed bond markets are active. The model of the economy is exactly the same as Cass' (1989) GEI model with the addition of the indexed bonds. Mas-Colell (1992) and Goenka and Prechac (2006) have shown that financial markets can be immune to sunspots by introducing real securities such as inflation-indexed bonds. However, the introduction of these real securities results in a complete shutdown of nominal financial markets. To resolve this unrealistic outcome, I assume that a transaction cost in intermediating indexed bonds exists. This paper shows that the market for money is always active with the transaction costs of indexed bonds. I also show that these bonds have a greater opportunity to be actively traded as the market has higher inflation volatility.;The third essay introduces a two-period monetary general equilibrium model with proportional transaction costs on nominal and inflation-indexed bonds. The main focus of this essay is to investigate the impact of introducing inflation-indexed bonds on nominal interest rates and the welfare of savers and borrowers. I demonstrate that this financial innovation on indexed bonds causes equilibrium interest rates of nominal securities to increase when agents have precautionary saving motives. This result implies that ignoring precautionary motives would underestimate savers' welfare gain and overestimates borrowers' welfare gain from innovation on indexed bonds. I show the main results of this paper by incorporating financial transaction costs and unstable monetary policies in the GE model and provide the rigorous proofs for existence and uniqueness of the equilibrium. I also provide the comparative statics of bond trading volume with respect to asymmetric transaction costs.;A static economy in which nominal taxes and transfers are balanced, as proposed by Balasko and Shell (1993), typically has a continuum of equilibrium money prices. The fourth essay presents a constructive example in which the set of equilibrium money prices is not connected. By allowing negative consumption as a mathematical construct, closed form solutions for equilibrium tax-adjusted income are derived.