DP2561 Does Money Illusion Matter? An Experimental Approach

Author(s): Ernst Fehr, Jean-Robert Tyran
Publication Date: September 2000
Keyword(s): Money Illusion, Nominal Inertia, Non-Neutrality Of Money, Sticky Prices
JEL(s): E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2561

Money illusion means that people behave differently when the same objective situation is represented in nominal terms rather than in real terms. This paper shows that seemingly innocuous differences in payoff representation cause pronounced differences in nominal price inertia indicating the behavioural importance of money illusion. In particular, if the payoff information is presented to subjects in nominal terms, price expectations and actual price choices after a fully anticipated negative nominal shock are much stickier than when payoff information is presented in real terms. In addition we show that money illusion causes asymmetric effects of negative and positive nominal shocks. While nominal inertia is quite substantial and long-lasting after a negative shock, it is rather small after a positive shock.