International transmission of shocks, money illusion and the velocity of money

Money illusion is "frequently invoked and frequently resisted" by economists. Resisted as it contradicts the maximizing paradigm of microeconomic theory and invoked since a tendency to think in nominal rather than real terms becomes evident in the behavior of agents. This paper rationalizes money illusion in an stylized open economy model considering that private agents learn nominal aggregate demand at a level different from the one imposed by rationality. We introduce a velocity of money shock revisiting the Quantity Theory of Money within the open economy micro-founded framework. An incomplete information game between Home and Foreign policymakers with monetary policy rules is developed, where sudden unstable financial conditions arise in one country, We find that the welfare effects of a productivity shock are increasing in the degree of money illusion and decreasing in the degree of openness of the economy. We find that allowing for velocity shocks reinforces the need for optimal monetary policy rules and to open the economies in order to avoid welfare costs.