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Money illusion and coordination failure


Fehr, Ernst; Tyran, Jean R (2007). Money illusion and coordination failure. Games and Economic Behavior, 58(2):246-268.

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 payoffs in nominal terms, choices converge to the Pareto inefficient equilibrium; however, if we lift the veil of money by representing payoffs in real terms, the Pareto efficient equilibrium is selected. We also show that strategic uncertainty about the other players’ behavior 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.

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 payoffs in nominal terms, choices converge to the Pareto inefficient equilibrium; however, if we lift the veil of money by representing payoffs in real terms, the Pareto efficient equilibrium is selected. We also show that strategic uncertainty about the other players’ behavior 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.

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19 citations in Web of Science®
24 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Economics
Dewey Decimal Classification:330 Economics
Language:English
Date:February 2007
Deposited On:26 Mar 2009 11:12
Last Modified:05 Apr 2016 12:28
Publisher:Elsevier
ISSN:0899-8256
Publisher DOI:10.1016/j.geb.2006.04.005
Permanent URL: http://doi.org/10.5167/uzh-3996

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