Working Paper: CEPR ID: DP4283
Authors: Ernst Fehr; Jean-Robert Tyran
Abstract: 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.
Keywords: Coordination Failure; Coordination Games; Equilibrium Selection; Money Illusion; Multiple Equilibria
JEL Codes: C90; E32; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| money illusion (E41) | inefficient equilibrium (equilibrium c) (D59) |
| money illusion (E41) | efficient equilibrium (equilibrium a) (D50) |
| nominal payoffs (G19) | coordination on inefficient equilibrium (equilibrium c) (D51) |
| real payoffs (J33) | coordination on efficient equilibrium (equilibrium a) (D51) |
| strategic uncertainty (D89) | coordination failures (P11) |
| individual-level money illusion (E41) | coordination on inferior equilibria (C72) |