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Monetary Policy and Economic Growth under Money Illusion

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  • Jianjun Miao

    ()
    (Department of Economics, Boston University)

  • Danyang Xie

    ()
    (Department of Economics, Hong Kong University of Science and Technology)

Abstract

Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into two stochastic continuous-time monetary models of endogenous growth. Motivated by psychology, we model an agent's money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent's perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is second order, whereas its impact on long-run growth is first order relative to the degree of money illusion. Monetary policy can eliminate this cost by correcting the distortions on a money-illusioned agent's consumption/savings decisions.

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Bibliographic Info

Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number wp2007-045.

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Length: 40
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Handle: RePEc:bos:wpaper:wp2007-045

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Keywords: money illusion; inflation; growth; welfare cost; behavioral macroeconomics;

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References

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Cited by:
  1. Basak, Suleyman & Yan, Hongjun, 2009. "Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion," CEPR Discussion Papers 7398, C.E.P.R. Discussion Papers.

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