IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion

  • Suleyman Basak
  • Hongjun Yan

This article analyzes the implications of money illusion for investor behavior and asset prices in a securities market economy with inflationary fluctuations. We provide a belief-based formulation of money illusion which accounts for the systematic mistakes in evaluating real and nominal quantities. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its welfare cost on investors is small in typical environments. A money-illusioned investor's real consumption is shown to generally depend on the price level, and specifically to decrease in the price level. A general-equilibrium analysis in the presence of money illusion generates implications that are consistent with several empirical regularities. In particular, the real bond yields and dividend price ratios are positively related to expected inflation, the real short rate is negatively correlated with realized inflation, and money illusion may induce predictability and excess volatility in stock returns. The basic analysis is generalized to incorporate heterogeneous investors with differing degrees of illusion.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://icfpub.som.yale.edu/publications/2402
Download Restriction: no

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2402.

as
in new window

Length:
Date of creation: 01 Oct 2008
Date of revision: 01 Aug 2009
Handle: RePEc:ysm:somwrk:amz2402
Contact details of provider: Web page: http://icf.som.yale.edu/

More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Markus K. Brunnermeier & Christian Julliard, 2006. "Money Illusion and Housing Frenzies," NBER Working Papers 12810, National Bureau of Economic Research, Inc.
  2. Fehr, Ernst & Tyran, Jean-Robert, 2004. "Money Illusion and Coordination Failure," CEPR Discussion Papers 4283, C.E.P.R. Discussion Papers.
  3. Süleyman Basak & Mike Gallmeyer, . "Currency Prices, the Nominal Exchange Rate, and Security Prices in a Two-Country Dynamic Monetary Equilibrium," Rodney L. White Center for Financial Research Working Papers 9-98, Wharton School Rodney L. White Center for Financial Research.
  4. Tarun Chordia & Lakshmanan Shivakumar, 2005. "Inflation Illusion and Post-Earnings-Announcement Drift," Journal of Accounting Research, Wiley Blackwell, vol. 43(4), pages 521-556, 09.
  5. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  6. Ernst Fehr & Jean-Robert Tyran, . "Does Money Illusion Matter?," IEW - Working Papers 012, Institute for Empirical Research in Economics - University of Zurich.
  7. Cochrane, John H, 1989. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," American Economic Review, American Economic Association, vol. 79(3), pages 319-37, June.
  8. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does it Work?," Yale School of Management Working Papers amz2648, Yale School of Management, revised 01 May 2008.
  9. Nicholas Barberis & Richard Thaler, 2002. "A Survey of Behavioral Finance," NBER Working Papers 9222, National Bureau of Economic Research, Inc.
  10. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887 Elsevier.
  11. Barr, David & Campbell, John, 1997. "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," Scholarly Articles 3163261, Harvard University Department of Economics.
  12. Clotilde Napp & Elyès Jouini, 2007. "Consensus consumer and intertemporal asset pricing with heterogeneous beliefs," Post-Print halshs-00152348, HAL.
  13. Hess, Patrick J & Lee, Bong-Soo, 1999. "Stock Returns and Inflation with Supply and Demand Disturbances," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 1203-18.
  14. repec:dau:papers:123456789/78 is not listed on IDEAS
  15. Jianjun Miao & Danyang Xie, . "Monetary Policy and Economic Growth under Money Illusion," Boston University - Department of Economics - Working Papers Series wp2007-045, Boston University - Department of Economics.
  16. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  17. Robert J. Shiller, 1997. "Public Resistance to Indexation: A Puzzle," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1), pages 159-228.
  18. N. Gregory Mankiw, 1985. "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly," The Quarterly Journal of Economics, Oxford University Press, vol. 100(2), pages 529-538.
  19. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2005. "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," The Quarterly Journal of Economics, Oxford University Press, vol. 120(2), pages 639-668.
  20. David Genesove & Christopher Mayer, 2001. "Loss Aversion and Seller Behavior: Evidence from the Housing Market," NBER Working Papers 8143, National Bureau of Economic Research, Inc.
  21. Randolph B. Cohen & Christopher Polk & Tuomo Vuolteenaho, 2005. "Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis," NBER Working Papers 11018, National Bureau of Economic Research, Inc.
  22. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
  23. Andrew Ang & Geert Bekaert & Min Wei, 2007. "The Term Structure of Real Rates and Expected Inflation," NBER Working Papers 12930, National Bureau of Economic Research, Inc.
  24. Daniel Kahneman, 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics," American Economic Review, American Economic Association, vol. 93(5), pages 1449-1475, December.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:ysm:somwrk:amz2402. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.