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Money Illusion and Coordination Failure

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  • Fehr, Ernst

    ()
    (University of Zurich)

  • Tyran, Jean-Robert

    ()
    (University of Copenhagen)

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.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 1013.

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Length: 32 pages
Date of creation: Feb 2004
Date of revision:
Handle: RePEc:iza:izadps:dp1013

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Keywords: money illusion; coordination failure; equilibrium selection; multiple equilibria;

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