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Limited rationality and strategic interaction: the impact of the strategic environment on nominal inertia


Fehr, Ernst; Tyran, Jean R (2008). Limited rationality and strategic interaction: the impact of the strategic environment on nominal inertia. Econometrica, 76(2):353-394.

Abstract

Much evidence suggests that people are heterogeneous with regard to their abilities to make rational, forward-looking decisions. This raises the question as to when the rational types are decisive for aggregate outcomes and when the boundedly rational types shape aggregate results. We examine this question in the context of a long-standing and important economic problem: the adjustment of nominal prices after an anticipated monetary shock. Our experiments suggest that two types of bounded rationality – money illusion and anchoring – are important behavioral forces behind nominal inertia. However, depending on the strategic environment, bounded rationality has vastly different effects on aggregate price adjustment. If agents’ actions are strategic substitutes, adjustment to the new equilibrium is extremely quick, whereas under strategic complementarity, adjustment is both very slow and associated with relatively large real effects. This adjustment difference is driven by price expectations, which are very flexible and forward-looking under substitutability but adaptive and sticky under complementarity. Moreover, subjects’ expectations are also considerably more rational under substitutability. KEYWORDS: Bounded rationality, strategic substitutes, strategic complements, money illusion, anchoring, nominal rigidity, sticky prices.

Abstract

Much evidence suggests that people are heterogeneous with regard to their abilities to make rational, forward-looking decisions. This raises the question as to when the rational types are decisive for aggregate outcomes and when the boundedly rational types shape aggregate results. We examine this question in the context of a long-standing and important economic problem: the adjustment of nominal prices after an anticipated monetary shock. Our experiments suggest that two types of bounded rationality – money illusion and anchoring – are important behavioral forces behind nominal inertia. However, depending on the strategic environment, bounded rationality has vastly different effects on aggregate price adjustment. If agents’ actions are strategic substitutes, adjustment to the new equilibrium is extremely quick, whereas under strategic complementarity, adjustment is both very slow and associated with relatively large real effects. This adjustment difference is driven by price expectations, which are very flexible and forward-looking under substitutability but adaptive and sticky under complementarity. Moreover, subjects’ expectations are also considerably more rational under substitutability. KEYWORDS: Bounded rationality, strategic substitutes, strategic complements, money illusion, anchoring, nominal rigidity, sticky prices.

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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:March 2008
Deposited On:17 Nov 2008 15:53
Last Modified:18 Feb 2018 09:31
Publisher:Wiley-Blackwell
ISSN:0012-9682
Additional Information:The definitive version is available at www.blackwell-synergy.com
OA Status:Green
Publisher DOI:https://doi.org/10.1111/j.1468-0262.2008.00836.x

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