does money illusion matter? - uzh · 2020. 8. 2. · does money illusion matter? by ernst fehr and...

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Year: 2001

Does Money Illusion Matter?

Fehr, Ernst ; Tyran, Jean-Robert

Abstract: This paper shows that a small amount of individual-level money illusion may cause considerableaggregate nominal inertia after a negative nominal shock. In addition, our results indicate that negativeand positive nominal shocks have asymmetric effects because of money illusion. While nominal inertia isquite substantial and long lasting after a negative shock, it is rather small after a positive shock.

DOI: https://doi.org/10.1257/aer.91.5.1239

Posted at the Zurich Open Repository and Archive, University of ZurichZORA URL: https://doi.org/10.5167/uzh-95345Journal Article

Originally published at:Fehr, Ernst; Tyran, Jean-Robert (2001). Does Money Illusion Matter? American Economic Review,91(5):1239-1262.DOI: https://doi.org/10.1257/aer.91.5.1239

Does Money Illusion Matter?

By ERNST FEHR AND JEAN-ROBERT TYRAN*

This paper shows that a small amount of individual-level money illusion may causeconsiderable aggregate nominal inertia after a negative nominal shock. In addition,our results indicate that negative and positive nominal shocks have asymmetriceffects because of money illusion. While nominal inertia is quite substantial andlong lasting after a negative shock, it is rather small after a positive shock. (JELC92, E32, E52)

Until recently, the notion of money illusionseemed to be thoroughly discredited in moderneconomics. James Tobin (1972) described thenegative attitude of most economic theoriststowards money illusion as follows: “An eco-nomic theorist can, of course, commit no greatercrime than to assume money illusion” (p. 3). Asa consequence, money illusion has been anath-ema to the profession for several decades. Theindex of the Handbook of Monetary Economics(Benjamin M. Friedman and Frank M. Hahn,1990), for example, does not even mention theterm “money illusion.” In principle, money il-lusion could provide an explanation for the in-ertia of nominal prices and wages and, thus, forthe nonneutrality of money. The stickiness ofnominal prices and wages seems to be an im-portant phenomenon (see, e.g., George A.Akerlof et al., 1996; Ben S. Bernanke andKevin Carey, 1996; David Card and DeanHyslop, 1997; Shulamit Kahn, 1997; Truman F.

Bewley, 1998; Alan S. Blinder et al., 1998). Ithas puzzled economists for decades because it isquite difficult to explain in an equilibriummodel with maximizing individuals. Instead ofmoney illusion other factors like informationalfrictions (Robert E. Lucas, Jr., 1972), staggeringof contracts (e.g., Stanley Fischer, 1977; JohnB. Taylor, 1979), costs of price adjustment (N.Gregory Mankiw, 1985), and near-rationality(Akerlof and Janet L. Yellen, 1985) have beeninvoked to explain nominal inertia.

In this paper we do not contest the potentialrelevance of these explanations. We do, how-ever, argue that money illusion has prematurelybeen dismissed as a potential candidate for theexplanation of sluggish nominal price adjust-ment. Our argument is based on rigorous exper-imental evidence from a price-setting game thatisolates money illusion from other potential de-terminants of nominal inertia. In particular, weshow that after a fully anticipated negative nom-inal shock, long-lasting nominal inertia pre-vails, even if informational frictions, costs ofprice adjustment and staggering are absent. Ourresults indicate that the direct and indirect ef-fects of money illusion are the major determi-nants of this long-lasting nominal inertia. Weshow, in addition, that money illusion causesmuch less nominal inertia after a fully antici-pated positive nominal shock. This result isreminiscent of the Keynesian proposition thatdownward wage rigidity causes asymmetric re-sponses to monetary shocks. Yet, since we ob-tain our result in a price-setting game, theasymmetric response cannot be directly relatedto downward wage rigidity. Our results suggestthat the asymmetry is caused by a particularform of money illusion arising from people

* Fehr: Institute for Empirical Research in Economics,University of Zurich, CH-8006 Zurich, Switzerland; Tyran:Department of Economics, University of St. Gallen, CH-9000 St. Gallen, Switzerland. We are particularly gratefulfor two excellent referee reports and for comments byGeorge Akerlof, Linda Babcock, Jim Cox, Urs Fischbacher,Simon Gächter, Ed Glaeser, Lorenz Goette, CharlesGoodhart, Reinhard Selten, Dick Thaler, Frans van Winden,and Michael Waldman. In addition, we acknowledge help-ful comments by the participants of many seminars aroundthe globe. Ernst Fehr gratefully acknowledges the hospital-ity of the Center for Economic Studies (CESIFO) in Mu-nich. Valuable research assistance has been provided byMartin Brown, Beatrice Zanella, and Tobias Schneider. Weare grateful for financial support by the Swiss NationalScience Foundation under Project No. 1214-051000.97/1,and by the EU-TMR Research Network (Project No.FMRX-CT98-0238).

1239

taking nominal payoffs as a proxy for real pay-offs. After a negative money shock, nominalpayoffs decline because prices tend to decline,while after a positive shock nominal payoffsincrease because prices tend to rise. If thesechanges in nominal payoffs are taken as a proxyfor changes in real payoffs there will be morereluctance to adjust prices to the new equilib-rium after a negative shock.

Our experiments also allow us to judge therelative importance of the direct and indirecteffects of money illusion on nominal inertia.The direct effects of money illusion are definedas those effects that are the direct result ofindividual optimization mistakes. The indirecteffects of money illusion are defined as thoseeffects that arise because some agents expectthat others are prone to money illusion and, as aconsequence, they behave differently. The dis-tinction between the direct and the indirect ef-fects of money illusion is important becausemany economists seem to believe that moneyillusion is not a widespread phenomenon at theindividual level, i.e., that the direct effects ofmoney illusion are small. The textbook examplewhere all nominal prices and nominal incomesare doubled nicely illustrates this view. It ishard to believe that many people make an indi-vidual optimization mistake by choosing a dif-ferent bundle of goods when prices and incomesare doubled. Our results clearly show, however,that it would be misleading to conclude thatmoney illusion is largely irrelevant because thedirect effects of money illusion are small. In ourexperiments the direct effects of money illusionon nominal inertia after the negative shock arealso rather small but the total effects neverthe-less are very large. The reason for this finding isthat money illusion renders price expectationsvery sticky after the negative shock, which—under conditions of strategic complementar-ity—induces agents to choose sticky prices.This result lends support to theories that stressthat small amounts of individual-level irratio-nality can have large aggregate effects (Akerlofand Yellen, 1985; John Haltiwanger andMichael Waldman, 1985, 1989; Thomas Russelland Richard Thaler, 1985). It also lends supportto the view of George W. Evans and GareyRamey (1992, 1998) that costly expectation for-mation causes expectations and prices to adjustonly gradually to the rational expectations equi-

librium. Although there are no direct costs offorming expectations in our experiments, it isquite likely that the task of forming expectationsinvolves cognitive costs. Taken together, theresults of our experiments suggest that moneyillusion matters, i.e., money illusion should beconsidered as a serious candidate in the expla-nation of nominal inertia.

The rest of the paper is organized as follows:In Section I we discuss the notion of moneyillusion and its potential aggregate implicationsin more detail. In Section II we argue thatexperimental methods are appropriate for study-ing whether money illusion matters and wepresent our experimental design. In Section IIIthe experimental results of the design with thenegative nominal shock are presented. SectionIV argues that the nature of money illusion inour experiment suggests that after a positivenominal shock there should be less nominalinertia. This conjecture is tested in a design witha positive nominal shock. In the final section wesummarize and interpret our main results.

I. Money Illusion at the Individual

and the Aggregate Level

A. Money Illusion at the Individual Level

Wassily Leontief (1936) defined money illu-sion as a violation of the “homogeneity postu-late.” This postulate stipulates that demand andsupply functions are homogeneous of degreezero in all nominal prices which means that theydepend only on relative and not on absoluteprices. Although other authors have usedslightly different definitions, the intuition be-hind their definitions seems to be rather similar.This intuition says that if the real incentivestructure, that is, the objective situation, an in-dividual faces remains unchanged, the real de-cisions of an illusion-free individual do notchange either. Two crucial assumptions underlythis intuition: First, the objective function of theindividual does not depend on nominal but onlyon real magnitudes. Second, people perceivethat purely nominal changes do not affect theiropportunity set. For example, people have tounderstand that an equi-proportionate change inall nominal magnitudes leaves the real con-straints unaffected. Whether people are, in fact,able to pierce the veil of money, i.e., whether

1240 THE AMERICAN ECONOMIC REVIEW DECEMBER 2001

they understand that purely nominal changesleave their objective circumstances unchanged,is an empirical question. Irving Fisher (1928),for example, was convinced that ordinary peo-ple are, in general, prone to money illusion.

More recently Eldar Shafir et al. (1997) pro-vided interesting questionnaire evidence indi-cating that frequently one or both preconditionsfor the absence of money illusion are violated.Their results suggest that the preferences ofmany people as well as their perceptions of theconstraints are affected by nominal values.Moreover, the answers of many people do notonly indicate that they themselves are prone tomoney illusion but that they also expect otherpeople’s behavior to be affected by moneyillusion.

Since the absence of money illusion meansthat an individual’s preferences, perceptionsand, hence, choices of real magnitudes are notaffected by purely nominal changes, it is naturalto view money illusion as a framing or repre-sentation effect. From this viewpoint, an indi-vidual exhibits money illusion if his or herdecisions depend on whether the same environ-ment is represented in nominal or real terms.There is a large body of experimental researchthat shows that alternative representations of thesame situation may well lead to systematicallydifferent responses (Reinhard Selten and ClausC. Berg, 1970; Amos Tversky and DanielKahneman, 1981). Representation effects seemto arise because people tend to adopt the par-ticular frame that is presented and evaluate theoptions within this frame. Because some op-tions loom larger in one representation than inanother, alternative framings of the same op-tions may provoke different choices.

It is important to note that the nominal rep-resentation of an economic situation is probablythe natural representation for most people. Thisis so because most economic transactions inpeople’s lives involve the use of money and,hence, are framed in nominal terms. Therefore,it is likely that people often perceive and thinkabout economic problems in nominal termswhich may induce money illusion. A ratherbasic form of money illusion occurs when peo-ple take nominal values or changes in nominalvalues as a proxy for real values or changes inreal values, respectively. Note that this rule ofthumb makes perfect sense in an environment

with a given aggregate price level. However,this rule is inappropriate in situations where theaggregate price level is changing. Therefore, theapplication of this rule in an environment withchanging aggregate prices constitutes a form ofmoney illusion.

B. Money Illusion at the Aggregate Level

In the past, economists frequently invokedthe assumption of money illusion to accountfor the short-run nonneutrality of money (e.g.,Fisher, 1928). However, since the success ofthe rational expectations revolution, econo-mists have been extremely reluctant to invokemoney illusion to explain the short-run non-neutrality of money. A common feature of themodels of New Classical and New Keynesianmacroeconomists is that they exclusively fo-cus on the equilibrium states of their econo-mies. In general, they remain silent on howeconomic agents move from one equilibriumto the other. In models that exclusively focuson equilibrium, the assumption of the absenceof money illusion is very intuitive because itis difficult to imagine that an illusion couldpersist in equilibrium. However, there is astrong a priori argument that money illusionis likely to affect the adjustment process of aneconomy after a fully anticipated monetaryshock. This argument is based on the simplefact that in an interactive situation the failureof some agents to fully adjust to the nominalshock will, in general, provide incentives forother agents to not fully adjust to the shock,either. Thus, there may be a snowball effectthat causes less than full adjustment for aprolonged period of time.

This can be illustrated in the context of amonopolistically competitive economy as ana-lyzed in, for example, Akerlof and Yellen(1985) or Olivier Jean Blanchard and NobuhiroKiyotaki (1987). To keep the argument simplewe focus solely on the firms’ behavior. Thereduced-form real profit function for firms inthese models can be written as

(1) p i 5 p i ~P i /P# , M/P# !, i 5 1, ... , n

where pi is firm i’s real profit, Pi is the nominalprice set by firm i, P# is the aggregate pricelevel, M denotes the supply of money, and n the

1241VOL. 91 NO. 5 FEHR AND TYRAN: DOES MONEY ILLUSION MATTER?

number of firms.1 In these models M/P# is pro-portional to real aggregate demand. For sim-plicity, we assume identical firms, the absenceof menu costs and informational frictions, and aunique and symmetric equilibrium P*i 5 P*j , forall i, j. In this equilibrium each firm maximizesreal profits by setting P*i 5 P# *. Since (1) ishomogeneous of degree zero in Pi , P# , and M, achange in M to lM (l Þ 1) leads to post-shockequilibrium values of lP*i and lP# *.

Suppose now that there is one group of agentswho suffers from money illusion and does,therefore, not fully adjust their nominal pricesto lP*i. Suppose further that there is a secondgroup of agents that anticipates the behavior ofthe first group. The second group, therefore,anticipates a change in real aggregate demandM/P# such that their members, in general, havean incentive to choose a price that differs fromlP*i , too. Whether the interaction between thesegroups causes aggregate nominal inertia de-pends in an important way on the strategic en-vironment, that is, whether agents’ actions arestrategic complements or strategic substitutes.Haltiwanger and Waldman (1989) have shownthat in the presence of strategic complementar-ity between agents’ decisions, the existence of asmall group of nonrational subjects can havelarge effects on the process of adjustment toequilibrium. In the above-mentioned model ofmonopolistic competition, strategic comple-mentarity means that firm i’s profit maximizingnominal price P9i is positively related to theaggregate price level P# . This means that firmswhich believe that, because of money illusion,the prices of other agents are kept close to thepre-shock equilibrium have a rational reason tochoose a nominal price that is also close to thepre-shock equilibrium.

Thus, under strategic complementarity ratio-nal firms have an incentive to partly imitate thebehavior of the nonrational firms which givesthe latter a disproportionately large impact onthe aggregate price level. In contrast, in thepresence of strategic substitutability, i.e., if P9i isnegatively related to P# , rational firms have an

incentive to partly compensate the behavior ofthe nonrational ones so that the latter have adisproportionately small impact on the aggre-gate outcome. The results of Haltiwanger andWaldman (1989) thus suggest that, given stra-tegic complementarity, the existence of a smallgroup of subjects that suffer from money illu-sion may generate substantial nominal inertia.However, while this is a plausible theoreticalargument, there is, to our knowledge, no empir-ical evidence for the claim that a small amountof money illusion may generate substantialnominal inertia.2

II. An Experimental Approach

to Money Illusion

One way to rigorously examine whethermoney illusion matters, is to look for a naturalexperiment in which an exogenous and fullyanticipated monetary shock occurs. In order tounambiguously identify whether the shock isfully anticipated, the researcher needs to knowindividual information sets before the shock. Tojudge whether the anticipated shock causes adisequilibrium and nominal inertia, the re-searcher has to know the equilibrium values ofnominal prices before and after the shock.Moreover, to examine whether money illusioncauses nominal inertia, the researcher shouldidentify two similar natural experiments. In oneexperiment the “world” should be framed innominal terms while in the other experiment itshould be framed in real terms. In our view, itseems extremely difficult, if not impossible, tomeet the above requirements with field data. Infact, the exogeneity of monetary policy and thecausality between money and output is a matterof considerable debate (e.g., Christina D.Romer and David H. Romer, 1989, 1994; KevinD. Hoover and Steven J. Perez, 1994; WilburJohn Coleman, 1996). In addition, full knowl-edge of the pre- and post-shock equilibrium

1 Equation (1) already incorporates (i) the maximizingbehavior of all households, (ii) the cost-minimizing behav-ior of all firms for given output and wages levels, (iii) theequilibrium real wage, and (iv) the equilibrium relationbetween real aggregate demand and real money balances.

2 Since strategic complementarity is important for ourargument in favor of the aggregate relevance of (beliefsabout) money illusion, one would like to know to whatextent it does prevail in naturally occurring economies.Seonghwan Oh and Waldman (1990, 1994), Russell Cooperand Haltiwanger (1996), and Blinder et al. (1998) provideevidence in favor of the relevance of strategic complemen-tarity in real economies.


values of nominal prices is clearly beyond theinformation content of presently available fielddata. In reality, almost all business transactionsare shrouded in nominal money, i.e., it is verydifficult to find real-world examples of a realframe.

In an appropriate laboratory setting, however,the above-mentioned data requirements can bemet. The techniques of experimental economicsallow the implementation of exogenous andfully anticipated nominal shocks and the exper-imenter can exert full control over pre- andpost-shock equilibrium values of nominalprices. In addition, the experimenter controlsthe framing of the situation, e.g., whether sub-jects receive the payoff information in nominalor in real terms. These enhanced control oppor-tunities suggest that laboratory experimentsprovide valuable information regarding the im-pact of money illusion on nominal inertia,which may complement and help to interpret theresults of studies based on field data (for fieldevidence see, e.g., Michael Abbott and OrleyAshenfelter, 1976; Beth T. Niemi and CynthiaB. Lloyd, 1981). The use of experimental meth-ods also distinguishes our examination from thestudy of Shafir et al. (1997). While these authorsasked subjects hypothetical questions, we di-rectly observe the evolution of individual andaggregate behavior after a nominal shock.

A. General Description of theExperimental Design

To study the impact of money illusion, wedesigned an n-player pricing game with stra-tegic complementarity and a unique equilib-rium. The pricing game was divided into apre-shock and a post-shock phase. All nplayers simultaneously had to determine theirnominal prices in each period of the game.

They were free to change their nominal pricesin each period at no cost. The players interactedanonymously via computer terminals. Eachtreatment condition had 2T periods. During thefirst T periods of a session the money supplywas given by M0. Then we implemented a fullyanticipated monetary shock by reducing themoney supply to M1. This shock and the factthat the post-shock phase again lasted T periodswas common knowledge.

Our major interest concerns subjects’ pricingbehavior in the post-shock phase. The pre-shockphase serves the purpose to make subjects ac-quainted with the computer terminal and thedecision environment. In addition, and moreimportantly, the pre-shock phase allows us tosee whether subjects reach equilibrium in thepre-shock phase. After all, one can only arguethat money illusion is a disequilibrating force ifequilibrium has in fact been reached before theshock.

The real payoff of subject i, pi , is given by

(2) p i 5 p i ~P i , P# 2i , M! i 5 1, ... , n

where Pi denotes i’s nominal price, P# 2i repre-sents the average price of the other n 2 1 groupmembers while M denotes a nominal shockvariable (money supply). The nominal payoff ofsubject i is given by P# 2ipi. In total, we havefour treatment conditions and the payoff func-tions (2) are the same in all conditions. The fourconditions differ along two dimensions (seeTable 1). The first dimension concerns the fram-ing of the situation, i.e., whether payoffs arerepresented in real or in nominal terms. In thereal treatments, denoted by RC and RH, subjectsreceived the payoff information in real termswhile in the nominal treatments, denoted by NCand NH, payoffs were represented in nominalterms. Thus, to compute their real payoffs in the

TABLE 1—TREATMENT CONDITIONS

Payoffs in Real Terms Payoffs in Nominal Terms

Computerized opponents Real treatment with computerized opponents(RC): 22 groups with 1 human and n 21 computerized players in each group

Nominal treatment with computerizedopponents (NC): 24 groups with 1human and n 2 1 computerizedplayers in each group

Human opponents Real treatment with human opponents (RH):10 groups with n human players in eachgroup

Nominal treatment with human opponents(NH): 11 groups with n human playersin each group


nominal treatments subjects had to divide theirnominal payoffs P# 2ipi by P# 2i.

The second dimension concerns the factwhether our experimental subjects face n 2 1preprogrammed computerized players orwhether they face n 2 1 other human subjects.The crucial point here is that in the computer-ized condition where one human subject facesn 2 1 preprogrammed computers, the subject isinformed about the aggregate response rule ofthe computers in advance. The response rule ofthe computers is given by the best replies of thecomputers [based on the computers’ payofffunctions (2)]. Therefore, there is no strategicuncertainty and, hence, no need to form expec-tations about the behavior of the other players inthis condition. Moreover, since the computersplay best replies, their behavior rules out anymoney illusion or any other form of irrational-ity. In contrast, in the condition with humanopponents each subject faces the task of form-ing expectations about the other players’ pricechoices. This necessarily also involves a guessabout the extent to which other players areaffected by money illusion.

The conditions with computerized players es-sentially boil down to individual decision-making experiments in which human subjectscan maximize their money earnings by playingoptimally against the known aggregate best re-ply of the n 2 1 computerized players. Notethat in the computerized conditions the indirecteffects of money illusion, which operate via theexpectations that other players are affected bymoney illusion, can play no role because thecomputers play best reply. These conditions,therefore, allow us to examine to what extentmoney illusion has direct effects on nominalinertia, i.e., to what extent it simply causesindividual optimization mistakes. In the condi-tions with human opponents the indirect effectsof money illusion can, in addition, also play arole.

The experimental design in Table 1 allows toisolate various potentially important determi-nants of nominal inertia. In the RC, moneyillusion is ruled out at the individual and, hence,also the aggregate level. Therefore, if we ob-serve in the RC a slow adjustment of the nom-inal price chosen by the human subject after theshock, money illusion cannot be the source ofthis nominal inertia. Thus, with the help of the

RC we can test the hypothesis whether there areindividual-level irrationalities other than moneyillusion.

In the NC, in contrast, money illusion canaffect the behavior of individuals because as apart of the individual optimization problem hu-man subjects have to correctly deflate nominalpayoffs at the various (Pi , P# 2i) combinations.Hence, by comparing the post-shock prices ofhuman subjects in the RC and the NC we canobserve whether there exists money illusion atthe individual level.

In the RH, as in the RC, individual-levelirrationality other than money illusion can playa role. However, in the RH the adjustment to thenew post-shock equilibrium is not just an indi-vidual optimization problem for the human sub-jects. In the RH, adjustment to the newequilibrium also involves the solution of a com-plex coordination problem.3 It cannot be takenfor granted that subjects instantaneously suc-ceed to act according to the new post-shockequilibrium. A plausible reason for this is thatthe complexity of subjects’ task is greater in theRH compared to the RC.

The RH and the RC are used to examineto what extent individual-level irrationalities,other than money illusion, together with thecoordination problem contribute to nominal in-ertia. The difference in price adjustment be-tween the RH and the RC measures the impactof the coordination problem plus the impact ofthe interaction between the coordination prob-lem and the individual irrationalities that are notrelated to money illusion. Interaction effectsoccur when these individual irrationalities causeslow adjustment by some subjects after theshock which—due to strategic complementar-ity—induces the other subjects to adjust slowly,too. A particularly interesting case arises if wefind no nominal inertia in the RC while in theRH nominal inertia prevails. In this case all ofthe nominal inertia in the RH can be attributedto the coordination problem because individual

3 There is an important literature on coordination prob-lems in macroeconomic models (see, e.g., Cooper, 1999)that is based on the existence of multiple equilibria. We usethe term “coordination problem” in a different way because,even in the case of a unique equilibrium, subjects face acoordination problem: Nash-equilibrium play presupposesthat subjects have coordinated (equilibrium) expectations.


irrationalities (other than money illusion) areabsent.

In the NH, subjects face the same coordina-tion problem as in the RH. We are, however,particularly interested in the impact of addingthe nominal frame to this coordination problem,i.e., in a comparison of the NH and the RH. Thiscomparison allows us to isolate the total effectsof money illusion in an environment where sub-jects face a coordination problem. The totaleffects of money illusion in this environmentconsist of the direct effects of individual-levelmoney illusion as exhibited in the NC plus theindirect “multiplier” effects of individual-levelillusion. These “multiplier” effects may arisebecause in our setting with human opponents,subjects with money illusion can also affect theexpectations and thus the behavior of the sub-jects without money illusion. If, for example,some subjects exhibit money illusion by taking(variations in) the nominal payoff as a proxy for(variations in) the real payoff, adjustment toequilibrium in the NH may be slower than in theRH. The reason is that after a negative shock,adjustment requires a decrease in nominal prices.By definition, a decrease in nominal prices isassociated with a decrease in nominal payoffnumbers in the NH. Therefore, subjects whoexhibit the above form of money illusion mis-takenly believe that real payoffs decrease withlower nominal prices. Thus, they prefer to stayat higher nominal prices, which may have adirect adjustment-reducing effect. Moreover, ifsome subjects believe that others suffer fromthis form of money illusion, they have an in-centive to slow down adjustment, too. In theRH, in contrast, this effect cannot occur becausepayoffs are represented in real terms. In the RH,it is, therefore, completely transparent that gen-eral price reductions are not associated withlower real payoffs.

If the deviation from the post-shock equilib-rium is larger and lasts longer in the NH com-pared to the RH, we have support for thehypothesis that money illusion contributes tonominal inertia. If, in addition, the price expec-tations are more sticky in the NH than in the RHwe have an indication for indirect effects be-cause the indirect effects become effective viasticky expectations. However, our design alsoenables us to isolate the indirect effects ofmoney illusion at the behavioral level. The dif-

ference in the deviations of the post-shock av-erage prices from equilibrium between the NCand the RC, DPNC 2 DPRC, measures theaggregate impact of individual-level money il-lusion on nominal inertia. Note that DPNC 2DPRC 5 PNC 2 PRC because the equilibriumprice is identical across conditions. The differ-ence between the NH and the RH, DPNH 2DPRH 5 PNH 2 PRH, measures the total ef-fects of money illusion which consist of theindividual-level effects plus the indirect effects.Thus, if there are no indirect effects of moneyillusion the total effects must be equal to theindividual-level effects: PNH 2 PRH 5 PNC 2PRC. If there are, however, indirect effects weshould observe that PNH 2 PRH . PNC 2PRC.4

B. General Properties of the Payoff Functions

Before we proceed to the specific numericalparameters of our experiment, it is useful toprovide a general description of the payoff func-tions (2). They have the following properties:

(i) They are homogeneous of degree zero in Pi ,P# 2i , and M.

(ii) The best reply is (weakly) increasing in P# 2i.

In addition, our functional specification5 ofequation (2) implies that the equilibrium

(iii) is unique for every M,(iv) is the only Pareto-efficient point in payoff

space, and(v) can be found by iterated elimination of

weakly dominated strategies.

4 Note also that if there are no individual irrationalitiesother than money illusion, DPRC 5 0, and the conditionfor the existence of indirect effects, DPNH 2 DPRH .DPNC 2 DPRC, can then be written as DPNH . DPRH 1DPNC. This means that if the deviation from equilibriumin the NH condition is larger than the summed devia-tions in the RH and the NC condition, indirect effectsprevail.

5 The functional form is presented in the Appendix.Readers who are interested in the full set of instructionsshould consult the Appendix in Fehr and Tyran (2000),which can be downloaded from http://www.iew.unizh.ch/wp/iewwp045.pdf. The instructions are also available fromthe authors upon request.


Note that the real payoff pi does not depend onthe average price P# of all group members but onP# 2i. This feature makes it particularly easy toplay a best reply for a given expectation aboutthe other players’ average price. If we made pidependent on P# , so that Pi affects P# , it wouldhave been much more difficult for i to computethe best reply (see also below). It is also worth-while to point out that the nominal payoff foreach subject i is given by P# 2ipi and not byP# pi. This makes the computation of the realpayoffs from a given nominal payoff much eas-ier because the deflator is independent of one’sown price choice.

Properties (i) and (iii) above were imple-mented because our analysis focuses on theimpact of money illusion on the adjustmentprocess of an economy with a unique money-neutral equilibrium P*i , i 5 1, ... , n. To seethat properties (i) and (iii) imply neutrality, notethat a change in M from M0 to lM0 leaves real pay-offs unaffected if prices change to lPi andlP# 2i. Moreover, if P9i , i 5 1, ... , n, is a bestreply to P# 2i at M0, lP9i also is a best replyto lP# 2i at lM0. Thus, lP*i for all i is thepost-shock equilibrium.

Property (ii) captures strategic complementa-rity and was implemented for the reasons givenin Section I, subsection B. In our pilot experi-ments we initially implemented a price-settinggame with monopolistic competition. However,it turned out that subjects quickly realized thatunder monopolistic competition cooperativegains can be achieved by out-of-equilibriumbehavior. Therefore, both in the nominal as wellas in the real frame, subjects systematicallytried to achieve real payoff gains through out-of-equilibrium behavior. Only towards the endof each phase these attempts vanished. Thus, inthe pre- as well as in the post-shock phase of ourpilot experiments, adjustment towards equilib-rium was strongly retarded by attempts to co-operate. To remove this confound with the othersources of nominal inertia we chose payofffunctions that ensured that the equilibrium wasthe unique Pareto-efficient point in the wholepayoff space [property (iv)].

Finally, property (v) means that there is amethod for finding the equilibrium that worksexactly in the same way in the real as well as inthe nominal frame. Note that the framing ofpayoffs has no impact at all on whether a par-

ticular strategy is (weakly) dominated. In thereal frame a (weakly) dominated strategy Pi has(weakly) smaller real payoff numbers at anylevel of P# 2i. In the nominal frame a (weakly)dominated strategy Pi has (weakly) smallernominal payoff numbers at any level of P# 2i.Thus, to eliminate (weakly) dominated strate-gies in either frame, subjects only need to elim-inate those strategies that have (weakly) smaller(real or nominal) payoff numbers at any givenlevel of P# 2i. Since, in the condition with humanopponents, the best-reply function and, hence,the number of (weakly) dominated strategies isexactly the same under the real and the nominalframe, there is, in the absence of money illu-sion, no reason why adjustment should differacross the RH and the NH.

C. Experimental Procedures and Parameters

All major experimental parameters are sum-marized in Table 2. The experiment was con-ducted in a computerized laboratory with agroup size of n 5 4. The group composition didnot change throughout the whole experiment,i.e., for 2T periods. In each group there weretwo types of subjects: Subjects of type x andsubjects of type y. Payoff functions differedamong the types. This difference implied thatx-types had to choose a relatively low price inequilibrium while y-types had to choose a rel-atively high price (see Table 2 for details).There is no particular reason for our choice ofthe group size because there are no strong con-jectures about the net effects of a differentgroup size. On the one hand, a larger group sizeenhances the chances that there are individualswith money illusion in a group. On the otherhand, the relative impact of an individual onaverage prices becomes smaller. With regard tothe heterogeneity of the players’ payoff func-tions, the case of four different payoff functionswould be the most realistic but also the mostcomplicated case. Therefore, we went for anintermediate solution with only two types ofplayers.6

In the pre-shock phase of each treatment the

6 The payoff functions of the two types were the same upto a parallel shift. Except for P*k and P# *k all parameters of thepayoff function specified in the Appendix are the same forboth types.


money supply was given by M0 5 42 while inthe post-shock phase it was given by M1 5M0/3 5 14. In the pre-shock equilibrium theaverage price over all n group members is givenby P# *0 5 18 while in the post-shock equilib-rium it is P# *1 5 6. In the treatments with humanopponents both the pre- and the post-shockphase consists of T 5 20 periods while in thetreatments with computerized opponents T 510. The reason for this difference was that weexpected that adjustment would take longer inthe presence of a coordination problem. For thepurpose of comparing post-shock nominal iner-tia across treatments it is crucial that the re-quired price adjustment, i.e., the differencebetween actual nominal prices in the final pre-shock period and the new post-shock equilib-rium price, is roughly the same. To ensurecomparable adjustment requirements acrosstreatments we gave players more time to reachthe equilibrium in the treatments with a coordi-nation problem.

In each decision period subjects had tochoose an integer Pi [ {1, 2, ... , 30}. Inaddition, they had to provide an expectationabout P# 2i which we denote by P# 2i

e . Finally,subjects indicated their confidence about their

expectation P# 2ie by choosing an integer from 1

to 6 where 1 indicated that the subject is “not atall confident” while 6 indicated that he or she is“absolutely confident.”7 This measure of confi-dence can be interpreted as an indicator of sub-jects’ perceived uncertainty about the otherplayers’ choices. Note that this uncertainty is aninevitable component of the coordination prob-lem that subjects face in the condition withhuman opponents. At the end of each periodeach subject was informed about the actual re-alization of P# 2i and the actual real payoff pi ona so-called outcome screen. In addition, theoutcome screen provided information about thesubject’s past choices of Pi , past realizations ofP# 2i , and past real payoffs pi.

Subjects received the payoff information inmatrix form.8 The payoff matrix shows the realand the nominal payoff, respectively, for each

7 The detailed meaning attached to the numbers is: 1 5not at all confident; 2 5 not much confidence; 3 5 not quiteconfident; 4 5 quite confident; 5 5 very confident; 6 5absolutely confident.

8 Appendix C of Fehr and Tyran (2000) contains thepayoff matrices of x- and y-types for all treatment condi-tions. See also footnote 5.

TABLE 2—EXPERIMENTAL DESIGN

Panel A: All PeriodsRepresentation of payoffs in the nominal frame P# 2ipiRepresentation of payoffs in the real frame piGroup size n 5 4Information feedback in period t P# 2i , piReal equilibrium payoff 40Choice variable Pi [ {1, 2, ... , 30}Length of pre- and post-shock phase in treatment with computerized opponents T 5 10Length of pre- and post-shock phase in treatment with human opponents T 5 20

Panel B: Pre-Shock ValuesMoney supply M0 42Average equilibrium price P# * and average equilibrium expectation for the whole group 18Equilibrium price for type x 9Equilibrium expectation P# 2i

e for type x 21Equilibrium price for type y 27Equilibrium expectation P# 2i

e for type y 15

Panel C: Post-Shock ValuesMoney supply M1 14Average equilibrium price P# * and average equilibrium expectation for the whole group 6Equilibrium price for type x 3Equilibrium expectation P# 2i

e for type x 7Equilibrium price for type y 9Equilibrium expectation P# 2i

e for type y 5


feasible integer combination of (Pi , P# 2i). Toinform subjects about the payoffs of the othertype, each subject also received the payoff ma-trix of the other type. This information condi-tion was common knowledge. The presentationof payoffs in the form of a matrix made itparticularly easy to find the best reply for anygiven P# 2i: The subject just had to look for thehighest real or nominal payoff in the columnassociated with P# 2i.

9 In fact, one of the firstthings most subjects did after we distributed theinstructions was to mark the best replies in thepayoff tables.

After subjects had read the instructions, butbefore the start of the experiment, each subjecthad to solve a series of exercises (see the Appen-dix in Fehr and Tyran, 2000). These exercisesinvolved the computation of their own payoff andthe payoff of their opponents for given hypothet-ical strategy profiles. In the nominal treatments, inparticular, subjects had to compute the real pay-offs from their nominal payoff tables for givenhypothetical strategy profiles. The subjects knewthat we did not start the experiment until everyparticipant in a session had solved all exercisessuccessfully. All subjects were in fact able to solvethe exercises. By this training procedure wewanted to rule out that subjects do not know howto properly deflate nominal values. It is quitelikely that this procedure diminished the amountof individual-level money illusion in our experi-ment. It was motivated by the question whether asmall amount of individual-level money illusionwill cause long-lasting nominal inertia in the NHbecause of the indirect effects of money illusion.Obviously, the case for the relevance of moneyillusion is stronger if we observe large indirecteffects.

In the treatments with computerized oppo-nents, subjects received the same instructionsand payoff tables as in the treatments with hu-man opponents. In addition, subjects were in-formed that the decisions of the other threeplayers in the group would be made by prepro-grammed computers. Subjects received an in-

formation sheet that informed them about theP# 2i response of the three computers to eachprice choice Pi [ {1, 2, ... , 30}. Fifty percentof the human subjects in these conditions wereendowed with the payoff function of anx-player, the other 50 percent had the payofffunction of a y-player.

At the end of the final pre-shock period thenominal shock was implemented in the follow-ing way: Subjects were publicly informed thatx- and y-types received new payoff tables.These tables were based on M1 5 M0/3. Againeach type received the payoff table for his ownand the other type. Subjects kept the pre-shocktables and were encouraged to compare the pre-and post-shock tables. They were told that, ex-cept for payoff tables, everything else wouldremain unchanged. They were given enoughtime to study the new payoff tables and tochoose Pi for the first post-shock period.

10 Thisprocedure ensured that in the first post-shockperiod subjects faced an exogenous and fullyanticipated negative nominal shock. At the be-ginning of this period it was also commonknowledge that the experiment would last foranother T periods.

Before we proceed to the experimental re-sults, it needs to be emphasized that in a givenphase the number of dominated price choices isidentical across all treatments. It is, however,not identical between the pre- and the post-shock phase. Since the money supply is lower inthe post-shock phase the number of dominatedstrategies is also lower in this phase. Note thatthe smaller number of dominated strategies in thepost-shock phase is an inevitable result of thefact that the money supply is reduced while thenominal strategy space and the nominal ac-counting unit is kept constant.11 Due to the

9 If a subject is uncertain about the true value of P# 2i , thecalculation of the best reply requires, of course, to take intoaccount the subjective distribution of P# 2i and not onlythe expectation of P# 2i. However, for simplicity, in thefollowing we will use the term “best reply” in the sense ofa best reply to the expectation of P# 2i.

10 Subjects were told that they had ten minutes to studythe new payoff tables and, in addition, three minutes tomake a decision for the first post-shock period. Yet, almostall subjects made their decision well before the 13 minuteshad elapsed. In the subsequent periods subjects also rarelyexhausted their time limits.

11 A change in the nominal price in the post-shock phase(i.e., at M0/3) by one unit has the same real effects as achange in the nominal price by three units in the pre-shockphase (i.e., at M0). This means that if a nominal price isstrictly dominated in the post-shock phase there will, ingeneral, be three nominal prices that are strictly dominatedin the pre-shock phase.


differences in the number of dominated strat-egies a comparison of the adjustment speedacross phases must take this difference intoaccount. The higher number of dominatedstrategies in the pre-shock phase means, inparticular, that the indirect effects of moneyillusion are likely to be smaller in this phase.This is so because, if a strategy is dominated,it is optimal to not play this strategy irrespec-tive of the expectations about other players’behavior. Thus, expectations about otherplayers’ money illusion necessarily have lessimpact and, as a consequence, one wouldexpect a quicker adjustment towards equilib-rium in the pre-shock phase. Note also thatthe different number of dominated strategiesacross phases is not a problem for the mainpurpose of our research. We are not interestedin comparing adjustment speed across phasesbut across treatments in the post-shock phase.For our purposes the crucial point is that inthe post-shock phase the number of domi-nated strategies is identical across treatmentsbecause the only difference in the payoff ta-bles concerns the framing of the payoffs.

III. Results

In total, 130 subjects participated in theexperiments described in Table 1.12 Twenty-two subjects participated in the real treatmentwith computerized opponents (RC) and 24subjects in the nominal treatment with com-puterized opponents (NC). Eleven groups offour human subjects participated in the nom-inal treatment with human opponents (NH)and ten groups in the real treatment withhuman opponents (RH). No subject partici-pated in more than one treatment. Subjectswere undergraduate students from differentdisciplines at the University of Zurich, Swit-zerland. They were paid a show-up fee ofCHF 15 (approx. $12 at that time) and theirtotal earnings from the experiment were onaverage CHF 35 (approx. $28) (including theshow-up fee). On average, an experimentalsession lasted 90 minutes.

A. Nominal Price Adjustment as anIndividual Optimization Problem

In this section, we address the questionwhether individual-level money illusion andother individual-level irrationality contribute tonominal inertia. Therefore, our discussion isconstrained to the RC and the NC, where ad-justment to the post-shock equilibrium is a pureindividual optimization problem. Our first mainresult is that in the RC all subjects instanta-neously adjust to the new post-shock equilib-rium, i.e., nominal inertia is completely absent.Support for this claim is provided by column 1of Table 3 and by Figure 1. Both the table andthe figure show the pre- and post-shock path ofthe average price of all human subjects in theRC. What is remarkable here is that, except fora few periods, the average price is exactly equalto the equilibrium price of P# *0 5 18 in the pre-and P# *1 5 6 in the post-shock period. More-over, it is not just the average that coincideswith equilibrium. In most periods literally allsubjects play the equilibrium. This result con-trasts with what we observe in the nominalframe. In the NC there is a small amount ofnominal inertia since some subjects do not fullyadjust prices to the new post-shock equilibrium.This claim is supported by Table 3 (column 2)and Figure 1. Both the table and the figure showthat the evolution of average prices is, in gen-eral, more volatile relative to the RC. This sug-gests that at least some subjects in the NC haveproblems in finding the optimal solution to theirmaximization problem. Moreover, while in theRC all subjects instantaneously adjust theirprices fully to the post-shock equilibrium, in theNC only 80 percent of the subjects do so. Therest of the subjects choose prices above theequilibrium so that in the first post-shock periodthe average price is by 2.1 units too high.Throughout the whole post-shock phase the NCmost of the time is close but never exactly inequilibrium which contrasts again with the RCwhere after the second post-shock period allsubjects are exactly in equilibrium almost all ofthe time.

These differences in post-shock adjustmentalso give rise to differences in the real incomelosses across RC and NC. Nominal inertia in theNC causes small but nonnegligible real incomelosses in the post-shock phase. In contrast, in

12 In follow-up experiments with a positive moneyshock, described in detail in Section IV, another 96 subjectsparticipated.


the RC there are no or only extremely small realincomes losses in the post-shock phase. To ver-ify this claim we calculate by how much actualreal income of player i, pi , falls short of realincome in equilibrium p*. For this purpose wehave computed «it [ (p* 2 pit)/p* for allplayers in each period t. «it is a measure of theincome loss relative to the equilibrium payoff asa percentage of the equilibrium payoff. Since

the equilibrium is efficient it is also a measureof the efficiency loss. Columns 5 and 6 of Table3 present the evolution of the average value of«it over all players in the RC and in the NC. Thetwo columns indicate that after the shock theaverage efficiency loss is most of the time zeroin the RC and always lower than in the NC.

Taken together, the results of the treatmentswith computerized opponents indicate that there

TABLE 3—EVOLUTION OF PRICES AND EFFICIENCY LOSSES OVER TIME

Period

Average Price Average Efficiency Loss (Percent)

Computerizedopponents Human opponents

Computerizedopponents Human opponents

Real(RC)

Nominal(NC)

Real(RH)

Nominal(NH)

Real(RC)

Nominal(NC)

Real(RH)

Nominal(NH)

220 17.6 18.5 14.4 19.0219 18.2 19.3 21.5 14.6218 17.8 19.1 14.1 10.2217 17.7 19.4 9.5 11.7216 17.9 19.2 8.8 6.8215 18.3 19.1 10.8 13.2214 17.6 18.2 8.0 9.9213 17.9 18.6 8.2 4.2212 17.9 18.7 6.3 3.1211 17.6 18.3 5.5 7.5210 17.9 15.2 17.8 18.4 1.0 16.4 9.4 3.429 18.1 17.0 17.5 18.2 0.5 12.6 3.6 1.628 17.8 17.2 17.6 19.0 1.6 9.0 3.3 6.027 18.0 18.0 17.7 18.3 0.5 3.0 2.4 1.826 17.6 17.2 17.6 18.2 2.4 10.4 10.9 1.325 18.0 17.7 18.1 18.3 0.3 5.4 7.0 2.724 18.0 18.1 18.1 18.4 0.0 3.5 7.3 2.523 17.8 16.1 17.6 18.6 1.3 12.6 3.7 2.822 18.4 18.3 17.9 18.2 2.3 1.9 2.2 0.721 18.0 17.0 18.0 18.2 0.0 5.3 0.9 0.9

1 6.0 8.1 9.1 13.1 0.0 10.4 51.8 65.12 7.0 7.4 7.7 12.9 3.6 8.2 20.0 47.53 6.0 6.8 7.4 11.4 0.0 4.4 15.0 34.84 6.0 6.4 6.9 10.4 0.6 6.5 9.1 27.45 6.0 6.9 7.0 9.9 0.0 8.0 14.8 17.46 6.0 6.8 6.6 10.2 0.0 15.6 7.7 15.97 6.0 7.5 6.3 9.7 0.0 9.3 4.5 16.48 6.0 6.8 6.4 9.1 0.0 15.5 4.6 10.79 6.0 6.5 6.3 8.7 0.0 4.3 3.8 9.5

10 5.9 6.5 6.8 8.6 1.6 3.8 11.0 13.811 6.1 8.1 4.6 8.212 6.2 7.6 3.3 6.413 6.2 7.2 2.1 6.214 6.2 6.9 2.8 4.615 6.1 6.7 2.6 2.616 6.1 7.3 2.1 9.617 6.0 6.8 0.9 5.218 6.1 7.2 1.8 14.219 6.1 7.5 1.4 12.520 6.2 7.0 3.0 2.4


is a small amount of money illusion at theindividual level but beyond that there is noindividual irrationality. The small amount ofindividual-level money illusion is suggested bythe small price differences between the NC andthe RC after the shock. The absence of otherforms of individual irrationality is suggested bythe perfect adjustment to the shock and thegenerally high incidence of equilibrium play inthe RC.

B. Nominal Price Adjustment as aCoordination Problem

The fact that in the RC the adjustment to thepost-shock equilibrium is perfect makes the in-terpretation of the deviation of prices from thepost-shock equilibrium in the RH particularlyeasy. It means that the whole deviation is due tothe fact that subjects in the RH face a relativelycomplex coordination problem. The major factsabout price adjustment in the RH are displayedin Table 3 and Figure 1. Column 3 of Table 3

shows that in the first post-shock period averageprices in the RH are 3.1 units above the averageequilibrium price of P# *1 5 6. This deviationquickly decreases to 1.4 units in period 3 andafter period 4 the deviation is never larger thanone unit. This pattern of average behavior is notan artifact of aggregation but is also revealed atthe level of individual choices. In the final pre-shock period 93 percent of the subjects in theRH play exactly their equilibrium strategies. Inthe first post-shock period only 35 percent of thesubjects play the new equilibrium and 23 per-cent of the subjects are only one or two priceunits above the equilibrium. The other 42 per-cent are more than two units above the equilib-rium. Yet, after only three periods thedistribution of individual price choices hasmoved much closer to the equilibrium. In period4, 45 percent of all subjects play exactly theequilibrium, 48 percent are one or two unitsabove and only 7 percent are more than two unitsabove the equilibrium. This post-shock evolu-tion of prices indicates that the coordination

FIGURE 1. EVOLUTION OF AVERAGE PRICES


problem initially causes considerable nominalinertia but that after a few periods this effect israther small because prices are again close tothe equilibrium.

Our description of the pattern of nominalinertia in the RH is also supported by formalstatistical tests. To check how long averagegroup prices in the RH and the NH deviatesignificantly from the equilibrium we ran thefollowing regression for the post-shock phase:

(3) P# it 2 P# *1 5 Ot 5 1

19

a t d t 1 Ot 5 1

20

b t ~1 2 d t !

where P# it denotes the average price of group iin period t. dt 5 1 if the price observation inperiod t comes from the RH. The coefficients atmeasure the deviation from equilibrium in theRH while the coefficients bt measure the devi-ation in the NH.13 The results of regression (3)are summarized in Table 4. The table showsthat, at the 5-percent level, average prices in theRH deviate significantly from the equilibriumfor two periods. Yet, from period 3 onwards, thehypothesis that average prices are in equilib-rium can no longer be rejected.14

To what extent is nominal inertia in the RHassociated with real income losses? Column 7of Table 3 indicates that in the first post-shockperiod the real income loss resulting from dis-equilibrium is quite considerable (52 percent).Yet, due to the relatively quick adjustment ofnominal prices after this period, the real incomeloss declines substantially and after the fifthpost-shock period it is—except for period 10—always below 10 percent. In the final periods thereal income loss is always rather small whichreflects the high incidence of equilibrium play.

The key difference between the RC and theRH is the presence of a relatively complexcoordination problem in the RH. If subjects

perceive coordination as a difficult problem thisshould be reflected in subjects’ confidence inP# 2i

e . In the first few pre-shock periods, sub-jects’ average confidence is at a level of 4 whichmeans that they are, on average “quite confi-dent.” The high frequency of equilibrium playbefore the shock then causes a general increasein the confidence level. In the last five pre-shockperiods, subjects exhibit, on average, a confi-dence level between 5 and 5.5. This means thatmost subjects are “very confident” (5 level 5)or even “absolutely confident” (5 level 6) thatthey have correct expectations. The anticipatednegative money shock causes, however, a con-siderable decrease in subjects’ confidence. Inthe first post-shock period, subjects are on av-erage “not quite confident” (level 3) or “quiteconfident” (level 4) that their expectations willbe correct. It takes about eight periods untilpre-shock confidence levels are again estab-lished. This indicates that the money shock in-deed causes a considerable coordinationproblem for the subjects.

Taken together, the evidence suggests that

13 To prevent linear dependence among the set of regres-sors, we included no dummy variable for period 20 ofthe RH.

14 We also examined the null hypothesis that prices inthe RH differ from prices in the RC by means of nonpara-metric tests with individual data. The null hypothesis ofequal price distributions and of equal average prices can berejected for the first four post-shock periods at the 10-percent level (Kolmogorov-Smirnov Test and Mann-Whitney Test).

TABLE 4—DEVIATION FROM POST-SHOCK EQUILIBRIUM INTREATMENTS WITH HUMAN OPPONENTS

Post-ShockPeriod

Real Treatment withHuman Opponents(RH) Coefficient at

Nominal Treatmentwith Human Opponents

(NH) Coefficient bt

1 3.10*** 7.14***2 1.68** 6.86***3 1.43 5.43***4 0.90 4.41***5 1.00 3.86***6 0.55 4.18***7 0.25 3.77***8 0.35 3.05***9 0.25 2.70***

10 0.83 2.59***11 0.13 2.05***12 0.23 1.61**13 0.18 1.1814 0.18 0.8915 0.10 0.7016 0.13 1.2517 0.03 0.8018 0.13 1.2019 0.05 1.4520 — 0.95

Notes: P# it 2 P# *1 5 ¥t 5 119 atdt 1 ¥t 5 1

20 bt(1 2 dt).dt 5 1 if price observation in period t is from RH.***Denotes significance at the 1-percent level.**Denotes significance at the 5-percent level.


the introduction of a coordination problem inthe real treatment causes initially a nonnegli-gible amount of nominal inertia that is associ-ated with considerable real effects. Yet, nominalinertia vanishes relatively quickly so that al-ready after a few periods prices are quite closeto the equilibrium.

C. Coordination in the Presenceof Money Illusion

Nominal inertia in the RH has nothing to dowith money illusion but is caused by the prob-lem to coordinate expectations and actions onthe new equilibrium. From the comparison be-tween the RC and the NC we already know thatindividual-level money illusion has a small pos-itive effect on nominal inertia. In the NH asmall amount of individual-level money illusionmay, however, cause important indirect effects.These indirect effects can arise because thepresence of individual-level money illusion islikely to affect subjects’ expectations, which inturn affect their behavior. If money illusionindeed causes such indirect effects we shouldobserve that the introduction of the nominalframe has a larger effect in the setting withhuman players than in the setting with comput-erized players. We should, in addition, also ob-serve that in the setting with human players thenominal frame gives rise to an increase in thestickiness of subjects’ price expectations.

Figure 1 and Table 3 (columns 3 and 4)provide the relevant information regarding theimpact of the nominal frame. They show thatnominal prices are indeed much stickier in theNH compared to the RH. In the final pre-shockperiod the overwhelming majority of the sub-jects play exactly the equilibrium both in the RH(93 percent) and the NH (80 percent). There-fore, average prices are very close to thepre-shock equilibrium P# *0 5 18. In the firstpost-shock period, however, only 11.5 percentof all subjects in the NH play exactly the equi-librium and 73 percent of the subjects are threeor more price units above the equilibrium. Incontrast, in the RH, 35 percent play exactly theequilibrium and, in addition, 23 percent are onlytwo or less price units above the new equilib-rium. These treatment differences in individualadjustment behavior also give rise to large dif-ferences in the average price level. In the first

post-shock period the average price in the NH is7.1 units above the equilibrium while in the RHthe deviation is only 3.1 units (see Table 3). Ittakes eight periods in the NH until the deviationof average prices from equilibrium decreases to3.1 units. These large differences in price ad-justment speed are also confirmed by formalstatistical tests. Table 4 reveals that in the NHthe hypothesis of equilibrium play can be re-jected at the 5-percent level for the first 12post-shock periods while in the RH it can onlybe rejected for two periods. Similar resultsemerge when we examine the null hypothesis ofequal average prices in the NH and the RH bymeans of a nonparametric Mann-Whitney Testwith individual data. For the first nine post-shock periods the null hypothesis can be re-jected already at the 2-percent level. For thenext three post-shock periods it can be rejectedat the 10-percent level.

To what extent is nominal inertia in the NHassociated with real income losses? Column 8 ofTable 3 indicates that shortly before the shock,subjects in the NH achieve almost full efficiency.The monetary shock leads, however, to a substan-tial real income loss. In the first period after theshock the average income loss is 65 percent andduring the first ten post-shock periods the loss isnever below 9.5 percent. Note also that throughoutthe whole post-shock period the income loss is ingeneral much higher in the NH than in the RHwhich is a consequence of the much stickier pricesin the NH. For example, in the first ten post-shockperiods of the NH, the aggregate real income lossis roughly twice as large as the loss in the RH. Intotal, groups in the NH lose 26 percent of thepotential payoff in the first ten post-shock periods.In the RH, the respective losses are slightly lessthan 14 percent. Thus, the evidence clearly indi-cates two results: (i) In the setting with humanplayers the introduction of a nominal frame haslarge and long-lasting effects on price stickiness.(ii) This increase in price stickiness is associatedwith a considerable increase in the real incomeloss caused by the anticipated money shock.

From Figure 1 and Table 3 we also can inferthat the nominal frame causes much stickier priceswhen money illusion can have indirect effects.Throughout the first ten post-shock periods theadjustment difference in average prices betweenthe NH and the RH, DPNH 2 DPRH 5 PNH 2PRH, is between two and 13 times larger than the


adjustment difference between the NC and theRC, DPNC 2 DPRC 5 PNC 2 PRC. It is, forexample, easy to infer from Table 3 that, in thesecond post-shock period, the adjustment differ-ence between the NH and the RH is 12.9 2 7.7 55.2 price units, while the difference between theNC and the RC is only 7.4 2 7.0 5 0.4 units.Hence, in this period the impact of the nominalframe is 13 times larger in the setting with humanplayers compared to the setting with computerizedplayers. In the tenth post-shock period the adjust-ment difference is still 1.8 units in the setting withhuman players and only 0.6 units in the settingwith computerized players. To substantiate theindirect effects of money illusion we also con-ducted period-wise t-tests for the null hypothesisthat the adjustment difference between the NHand the RH is bigger than between the NC and theRC. In five of the first ten post-shock periods thedifference between the NH and the RH is signif-icantly larger at the 5-percent level. In view of theconsiderable variance across the four conditionsthis is quite remarkable.15 Thus, the implementa-tion of the nominal frame has a much larger im-pact in the setting where money illusion can alsohave indirect effects.

If money illusion has indirect effects weshould also observe that expectations are stick-ier in the NH compared to the RH. Figure2 shows the evolution of the average price ex-pectations over time in both treatments. Thefigure shows that in the last few pre-shock pe-riods, expectations are in equilibrium in bothtreatments. In the post-shock phase there are,however, striking differences. While expecta-tions are very sticky in the NH they are far lesssticky in the RH. To provide statistical evidencefor this, we ran the same regression as in Table4 with expectations data. It turns out that, in theNH, expectations differ significantly from theequilibrium (at p , 0.05) for 13 periods whilein the RH they differ only for three periods.Thus, there can be little doubt that the nominalframe causes a large increase in the stickiness ofprice expectations. The next question then is, towhat extent this difference in expectationscauses differences in subjects’ price choices. Or

put differently, to what extent did subjects playa best reply to their expectations. The vast ma-jority of subjects in both treatments indeedplayed best replies to P# 2i

e . During the first tenpost-shock periods 84 percent of the subjects inthe RH choose exactly the payoff-maximizingprice in response to P# 2i

e and the rest of thesubjects chooses prices that were close to thebest reply. In the NH there are slightly fewersubjects (80 percent) who chose exact best re-plies during the first ten post-shock periods.Yet, as in the RH, the deviations from the exactbest reply were in general very small. The factthat most subjects responded to P# 2i

e with apayoff-maximizing price choice suggests thatthe greater stickiness of the expectations in theNH also caused a greater stickiness of actualprices in the NH.

IV. Nominal Inertia after

a Positive Money Shock

A. The Relevance of a Positive Money Shock

Our results so far indicate that the directeffects of individual-level money illusion arerelatively small. The introduction of the nomi-nal frame in the setting with computerized play-ers leads only to a small increase in nominalinertia. Nominal inertia is much more pro-nounced, however, when money illusion canalso affect players’ expectations and can, thus,also have indirect effects. In the NH, subjects’expectations are much stickier and, as a conse-quence, prices are much stickier. This raises thequestion of why expectations are so sticky inthe NH compared to the RH. We believe thatthe answer to this question can be found in theexistence of subjects who take nominal payoffsas a proxy for real payoffs. Subjects who applythis rule of thumb mistakenly believe that if allplayers choose relatively high prices, all willreap high real payoffs because they all reap highnominal payoffs. They mistakenly believe thatthere are real gains from jointly setting highprices. Such subjects will, therefore, be reluc-tant to cut their nominal prices after the negativemoney shock in the NH. Moreover, if the pres-ence of subjects who are reluctant to cut pricesis anticipated by other subjects, others will beinduced to cut their price insufficiently also.

It is important to note that the above rule of

15 There are two subjects in the NC condition who couldwell be classified as outliers. If we run the tests withoutthese two subjects the indirect effects are highly significantin the first nine post-shock periods.


thumb cannot become effective in the RH. Inthe RH the numbers in the payoff tables repre-sent real payoffs which makes it completelytransparent that at high nominal prices real pay-offs are not generally higher. This means thatthe presence of subjects who take nominal pay-offs as a proxy for real payoffs causes no reluc-tance to cut nominal prices after the negativeshock in the RH. These differences between theNH and the RH in the reluctance to cut nominalprices also provide a rationale for the muchstickier price expectations in the NH.

Yet, if the above explanation for the stickierexpectations in the NH is correct, we shouldalso observe that after a positive money shock,prices and expectations adjust more quickly tothe equilibrium than after a negative shock. Thisis so because after a positive shock, adjustmenttowards equilibrium means adjustment towardshigher prices and, hence, higher nominal pay-offs. A quicker adjustment after a positiveshock, however, does not mean that money il-lusion is absent when a positive shock occurs. It

only means that money illusion has a differentimpact after a positive shock compared to anegative shock. After a negative shock the ruleof thumb mentioned above causes a reluctanceto adjust prices (downwards) while after a pos-itive shock it does not cause a reluctance toadjust prices (upwards). Note further that whilethe rule of thumb implies a quicker adjustmentto equilibrium after a positive shock in the NH,the adjustment speed in the RH should not differacross positive and negative shocks. The reasonis that the rule of thumb cannot become opera-tive in the RH.

To test these implications of our explanationfor the much stickier expectations in the NH weconducted additional experiments with a posi-tive money shock. Forty-eight subjects (12groups) participated in the RH and another 48subjects (12 groups) participated in the NH withthe positive money shock. The easiest way toimplement a positive shock would be a reversalin the sequence of the money supply in ourprevious design. Unfortunately, this approach is

FIGURE 2. EVOLUTION OF AVERAGE EXPECTATIONS


not reasonable because the number of domi-nated strategies is much larger in the pre-shockphase than in the post-shock phase. Therefore,the indirect effects of money illusion can play amuch smaller role in the pre-shock phase. Thefact that prices in the NH adjust much morequickly to the equilibrium in the pre-shockphase than in the post-shock phase (see Figure1) is consistent with this argument. Therefore, ifwe just reversed the sequence of the moneysupply, we would probably observe that adjust-ment is indeed quicker after the positive shock.Yet, this increase in the adjustment speed wouldnot count as evidence for our explanation of thestickier expectations in the NH.

What is, therefore, needed, is an experi-mental design in which the number of domi-nated strategies is roughly the same after thenegative and after the positive shock. Ourparameterization of the design with the posi-tive shock serves this purpose. Except forthree aspects, all experimental details in thepositive-shock design are identical to thenegative-shock design. In particular, all fivefeatures of the payoff functions, as describedin Section II, subsection B, are also present inthe positive-shock design. The differences arethe following: (i) We did not implement com-puterized players in the positive-shock designbecause the main purpose of this design wasto observe whether the expectations of humanplayers and, hence, also prices adjust morequickly to the equilibrium after a positiveshock compared to the negative shock. (ii) Inthe positive-shock design the pre- and thepost-shock phase consisted of 15 instead of20 periods. This shortening of the phases wasimplemented because in the negative-shockdesign reliable equilibration was alreadyachieved after 10 –15 periods. (iii) To achieveroughly the same number of dominated strat-egies in the post-shock phase, equilibriumprices for x- and y-types in the positive-shockdesign were as follows: The pre-shock equi-librium price for x-types (y-types) is P*x 5 11(P*y 5 14) and the post-shock equilibriumprice is P*x 5 22 (P*y 5 28). As a conse-quence, the average pre-shock equilibriumprice in a group is P# *0 5 12.5 while in thepost-shock equilibrium it is P# *1 5 25. Thus,the difference in average prices between pre-and post-shock equilibrium is 12.5 in the positive-

shock design while it is 12 in the negative-shockdesign. This slightly bigger adjustment require-ment in the positive-shock design is, however,not a problem. If adjustment to equilibrium inthe NH is faster after the positive shock, this iseven more remarkable because it occurs despitethe slightly bigger adjustment requirement inthe positive-shock design.

B. Prices and Expectations after the PositiveNominal Shock

Table 5 shows the evolution of pre- andpost-shock average prices in the RH and theNH. In the NH pre-shock prices convergefrom above to the equilibrium P# *0 5 12.5 andas in the negative-shock design the vast ma-

TABLE 5—EVOLUTION OF PRICES AND EFFICIENCY LOSSESOVER TIME: POSITIVE SHOCK

Period

Average PriceAverage Efficiency

Loss (Percent)

Real(RH)

Nominal(NH)

Real(RH)

Nominal(NH)

215 13.0 14.9 14.7 26.3214 13.0 14.7 18.2 24.7213 12.7 14.6 10.7 20.7212 12.7 14.3 5.3 13.6211 12.7 14.3 6.1 20.5210 12.5 14.1 1.6 9.129 12.5 13.6 2.1 10.928 12.5 13.4 0.3 11.327 12.4 13.7 1.2 14.826 12.5 13.8 0.6 13.225 12.5 13.8 1.6 8.424 12.5 13.9 0.3 10.423 12.5 13.6 0.9 7.022 12.6 13.1 4.7 6.921 12.5 13.1 1.9 1.0

1 22.5 20.5 22.3 24.02 24.3 22.8 3.9 7.23 24.8 24.1 1.2 4.24 24.9 24.8 0.7 1.45 25.0 25.0 0.2 0.96 25.0 25.1 0.1 0.37 25.0 25.2 0.1 0.48 25.0 25.1 0.1 0.19 25.0 25.0 0.1 0.1

10 25.0 25.2 0.1 0.311 25.0 25.2 0.2 0.112 25.0 25.0 0.1 0.113 25.0 25.0 0.1 0.114 24.3 24.5 6.3 5.915 24.6 24.9 4.0 1.4


jority of individuals plays exactly the equilib-rium in the final pre-shock period. Then, inthe first post-shock period prices make a bigjump upwards to 20.5 and already in period 4after the shock, average prices are almostexactly at the new equilibrium of P# * 5 25.From that period onwards prices remain veryclose to the equilibrium. This contrastssharply with the adjustment process after thenegative shock where, throughout the wholepost-shock period, average prices never cameso close to the equilibrium. This difference inNH adjustment paths after the negative andthe positive shock is depicted in Figure 3. Theheavy line in Figure 3 shows the difference inthe post-shock deviations of average pricesfrom the equilibrium between the positive andthe negative shock.16 The graph reveals towhat extent in the NH the adjustment gap,i.e., the deviation of average prices from theequilibrium, is larger after the negative shock

than after the positive shock. It shows that thedeviation from equilibrium is substantiallylarger after the negative shock. Between pe-riod 2 and 7, e.g., the adjustment gap is fouror more units bigger after the negative shock.Even in period 10 the adjustment gap is stillalmost three units bigger.

The impression conveyed by Figure 3 is con-firmed by a more formal statistical analysis. Ifwe perform regression (3) with the data after thepositive shock, it turns out that in the NH the

16 Let P# *11 be the post-shock equilibrium price in thepositive-shock design and let P# 1 be the actual post-shockaverage price. Analogously, let P# 2 be the actual post-shockaverage price in the negative-shock design and denote thepost-shock equilibrium price in this design by P# *12. Thenthe heavy line in Figure 3 is given by (P# 2 2 P# *12) 2(P# *11 2 P# 1), which measures the difference in the averagedeviations from equilibrium across the positive and thenegative shock for the first 15 periods of the post-shockphase in the NH.

FIGURE 3. DIFFERENCES IN DEVIATIONS FROM EQUILIBRIUM ACROSS THE NEGATIVE AND THE POSITIVE SHOCK


hypothesis of equilibrium play can only be re-jected for the first three periods (at the 5-percentlevel). Remember that after the negative shock,group prices were significantly above the equi-librium for 12 periods. Thus, the evidence un-ambiguously indicates that adjustment in theNH is much quicker after the positive shock,which is consistent with our hypothesis thatthere is less reluctance against adjustment afterthe positive shock.

If there is indeed less reluctance against ad-justment after the positive shock, at least somesubjects should anticipate this. Therefore weshould also observe that expectations are lesssticky after the positive shock. The dashedheavy line in Figure 3 shows the difference inthe post-shock deviations of the average expec-tations of P# 2i from the equilibrium between thepositive and the negative shock. This graph isconstructed analogously to the heavy line inFigure 3 except that we used the expectationsP# 2i

e to construct it. Thus the dashed heavy lineshows to what extent the adjustment gap in theexpectations, i.e., the deviation of average ex-pectations from equilibrium, is larger after thenegative shock than after the positive one. Thegraph indicates that the adjustment gap in theexpectations is much larger after the negativeshock for many time periods. Interestingly, thegraph is hump-shaped, i.e., the relative sticki-ness of expectations after the negative shockincreases in the first few periods. This is due tothe fact that between period 2 and 5 after thepositive shock, expectations rapidly converge toequilibrium while they are very sticky after thenegative shock.

Finally, since the rule of thumb of takingnominal payoffs as a proxy for real payoffscannot be operative in the RH, we shouldobserve no differences in price adjustment inthe RH across negative and positive shocks.Table 5 shows the evolution of average pricesin the RH after the positive shock and Figure3 illustrates the differences in average pricesand average expectations across shocks. Ta-ble 5 indicates that in the pre-shock phase ofthe RH the average price is very close to theequilibrium P# *0 5 12.5 already after threeperiods. Immediately after the positive shockthere is a big upward jump in prices to 22.5,only 2.5 units below the new equilibrium.Already in the third post-shock period the

average price is again very close to the equi-librium. This indicates that price adjustmentafter the positive shock is rather quick in theRH—similar to the pattern after the negativeshock. This similarity is also displayed inFigure 3 and by formal statistical analysis.The thin line in Figure 3 is constructed anal-ogously to the heavy line except that we usethe price data from the RH. It shows that priceadjustment in the RH is only slightly fasterafter the positive shock. If we perform regres-sion (3) with the post-shock data from thepositive-shock design we get the followingresults: The hypothesis that average prices inthe RH are in equilibrium can only be rejectedfor the first two periods (at the 5-percentlevel). Note that this is exactly the same num-ber of out-of-equilibrium periods as after thenegative shock. This suggests that the differ-ences in the price adjustment across shocks inthe RH are indeed negligible. The dashed thinline in Figure 3, which is constructed analo-gously to the dashed heavy line except thatwe use the expectations data from the RH,indicates that we can basically make a similarconclusion with regard to the differences inthe adjustment of expectations across shocks.While in the NH there are large differences inthe stickiness of expectations across shocks,in the RH the differences in expectations arerather small.

Thus all major regularities are consistentwith our hypothesis that there are beliefs thatsome subjects take nominal payoffs as aproxy for real payoffs. Nonetheless, it wouldbe reassuring if subjects themselves ex-pressed such a belief. To check to what extentsubjects indeed believed this they could indi-cate their degree of agreement with the fol-lowing statement after the experiment: “Ibelieved that the other subjects would inter-pret high nominal payoffs as an indicator forhigh real payoffs.” Participants could indicatewhether they weakly (dis)agreed, whetherthey strongly (dis)agreed or whether they to-tally (dis)agreed with this statement. Thirtypercent of the subjects in the NH agreed ei-ther “strongly” or “totally” and further 25percent indicated a weak agreement. In ourview, this can be taken as direct evidence thata majority of the subjects believed that othersubjects were affected by money illusion. In


any case, these answers nicely fit with ourexplanation for the large amount of nominal iner-tia observed in the NH after the negative shock.

V. Summary and Concluding Remarks

Most economic transactions are representedin nominal terms. Therefore, it seems likely thatpeople often perceive and think about economicproblems in nominal terms which may inducemoney illusion. However, for several decadesmoney illusion has been considered as largelyirrelevant for the nominal inertia of aggregateprice levels. Instead, most economists have fo-cused on informational frictions, costs of priceadjustment, and staggered contracts. This papershows, however, that even in the absence ofthese factors a fully anticipated negative nomi-nal shock can cause long-lasting nominal inertiathat is associated with large real income lossesduring the adjustment phase. Our results indi-cate that a large part of this nominal inertia canbe attributed to the direct and indirect effects ofmoney illusion. The experiments in the settingwith computerized opponents show that the di-rect effects of money illusion in the form ofindividual optimization mistakes are not veryfrequent: The introduction of the nominal framein the setting with computerized opponentscauses only a small amount of nominal inertia.However, the combined direct and indirect ef-fects of money illusion generate a very largeincrease in nominal inertia. This is indicated bythe fact that the introduction of the nominalframe in the setting with human opponentscauses a huge increase in the sluggishness ofprices. Instead of two it takes 12 periods untilaverage prices reach the post-shock equilibriumin this setting.

The major cause for nominal inertia after thenegative shock is that subjects’ expectations arevery sticky. In our view this stickiness of priceexpectations is related to the nature of moneyillusion in our experiment, i.e., to the belief thatthere are subjects who take nominal payoffs asa proxy for real payoffs. This conjecture issupported by direct questionnaire evidence andby the results of further experiments with a fullyanticipated positive nominal shock. It turns outthat price sluggishness is much smaller after apositive nominal shock than after the negativeshock. This result is also interesting insofar as

there is field evidence indicating that positiveand negative money shocks have asymmetriceffects. While negative shocks have an output-reducing effect, positive shocks do not seem toaffect output (James Peery Cover, 1992; J.Bradford DeLong and Lawrence H. Summers,1988). The asymmetric effects of money illu-sion on price sluggishness can be considered asa potential microfoundation for this result.

Finally, another interesting result of our ex-periments is that we isolate—in addition tomoney illusion—a further source of nominalinertia. This source is related to the fact that ina strategic situation subjects do not merely facean individual optimization problem but thatthey also have to predict other agents’ behavior.After any shock, the new equilibrium can onlybe achieved if subjects have coordinated (equi-librium) expectations. The comparison of ad-justment paths in the real treatments withcomputerized and with human opponents showsthat after a fully anticipated nominal shock, itcannot be taken for granted that subjects instan-taneously succeed in solving this coordinationproblem. They will, in general, go through aperiod of disequilibrium that is associated withnominal inertia. Note, however, that the coordi-nation problem alone causes substantially lessnominal inertia than money illusion. It also doesnot cause asymmetric effects: In the real treat-ment with human opponents the extent of nom-inal inertia is very similar after the positive andthe negative nominal shock.

These results show that experiments can be auseful tool for the examination of the nature, theextent, and the impact of money illusion instrategic economic interactions. There are manyother questions that could be usefully tackled byexperimental methods. One open question ishow subjects who are familiar with moneyshocks in our pricing game will respond to newshocks. Future research should thus examinehow the adjustment pattern varies when expe-rienced subjects face a series of differentshocks. Other interesting questions concern thenature of nominal wage rigidity and the inter-action of price and wage policies during adjust-ment. To answer these questions it is necessaryto introduce workers as separate players in thegame. The analysis of the interaction betweenwage and price setting may prove particularlyuseful because there are likely to be strong


natural complementarities. For example, iffirms anticipate that workers will resist wagecuts after a negative money shock they willprobably be reluctant to cut prices becausethis would reduce their profits. Yet, if pricesstay high, workers may feel justified in resist-ing wage cuts. Thus, the reluctance to cutwages and prices could be mutually reinforc-ing for an extended period of time. Finally,another interesting question concerns how theimpact of money illusion varies with the de-gree of strategic complementarity. Is a lowerdegree of complementarity associated withless aggregate nominal inertia or not? Or,more fundamentally, does the impact ofmoney illusion vanish in an environment withstrategic substitutability?

In our view the results of our experimentsindicate that money illusion should be con-sidered as a serious candidate in the explana-tion of nominal inertia and the real effects ofnominal shocks. Paraphrasing Abraham Lin-coln,17 one can say that, to render money

illusion behaviorally relevant, it is not neces-sary to fool all the people some of the time,not to speak of fooling all the people all thetime. All that is needed is an environmentwith strategic complementarity and the pres-ence of a small amount of money illusion atthe individual level—a presupposition thatseems quite plausible.

APPENDIX: PAYOFF FUNCTIONS

As explained in detail in Section II, subsec-tions B and C, payoffs were presented to subjectsin payoff tables. These tables were calculatedfrom the payoff functions explained below. A fullset of payoff tables is contained in Fehr andTyran (2000) which can be downloaded fromhttp://www.iew.unizh.ch/wp/iewwp045.pdf. Thepayoff tables are also available from the authorsupon request.

The real payoff for agent i of type k 5 x, yis given by:

p ik 5

V z F1 1 a z D2

1 1 b z D2G1 1 c z FSP ikM 2

P*k

MD 2 d z D 1 e z arctan~ f z D!G

2 .

P# 2ik is the actual average price of the othern 2 1 players from the viewpoint of player iwho is of type k. P# *k is the equilibrium averageprice of the other n 2 1 players from theviewpoint of a player of type k. Pik is the actualprice of i who is of type k. P*k is the equilib-rium price of a player of type k. Finally,D 5 (P# 2ik/M) 2 (P# *k/M). The parameters forM and all equilibrium values can be found inTable 2.

In all periods and all experimental sessions

the parameters a, b, c, d, e, f, and V were thesame. They were given by a 5 0.5, b 5 0.6,c 5 27, d 5 1, e 5 0.05, f 5 20 and V 5 40.

REFERENCES

Abbott, Michael and Ashenfelter, Orley. “LabourSupply, Commodity Demand and the Alloca-tion of Time.” Review of Economic Studies,October 1976, 43(3), pp. 389–411.

Akerlof, George A.; Dickens, Williams T. and

Perry, George L. “The Macroeconomics ofLow Inflation.” Brookings Papers on Eco-nomic Activity, 1996, (1), pp. 1–59.

Akerlof, George A. and Yellen, Janet L. “A Near-rational Model of the Business Cycle, with

17 In his speech on September 8, 1858, Lincoln said:“You can fool all the people some of the time, and some ofthe people all the time, but you cannot fool all the people allthe time.”


Wage and Price Inertia.” Quarterly Journalof Economics, 1985, Supp., 100(5), pp. 823–38.

Belongia, Michael T. “Measurement Matters: Re-cent Results from Monetary Economics Re-examined.” Journal of Political Economy,October 1996, 104(5), pp. 1065–83.

Bernanke, Ben S. and Carey, Kevin. “NominalWage Stickiness and Aggregate Supply in theGreat Depression.” Quarterly Journal ofEconomics, August 1996,

does money illusion matter? - uzh · 2020. 8. 2. · does money illusion matter? by ernst fehr and...

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