DP4283 Money Illusion and Coordination Failure

Author(s): Ernst Fehr, Jean-Robert Tyran
Publication Date: March 2004
Keyword(s): coordination failure, coordination games, equilibrium selection, money illusion, multiple equilibria
JEL(s): C90, E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4283

Economists long considered money illusion to be largely irrelevant. Here we show, however, that money illusion has powerful effects on equilibrium selection. If we represent pay-offs in nominal terms, choices converge to the Pareto inefficient equilibrium; however, if we lift the veil of money by representing pay-offs in real terms, the Pareto efficient equilibrium is selected. We also show that strategic uncertainty about the other players? behaviour is key for the equilibrium selection effects of money illusion: even though money illusion vanishes over time if subjects are given learning opportunities in the context of an individual optimization problem, powerful and persistent effects of money illusion are found when strategic uncertainty prevails.