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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.

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File URL: http://icfpub.som.yale.edu/publications/2402
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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2402.

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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/

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  17. 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.
  18. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," 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 18, pages 1053-1128 Elsevier.
  19. Raghubir, Priya & Srivastava, Joydeep, 2002. " Effect of Face Value on Product Valuation in Foreign Currencies," Journal of Consumer Research, University of Chicago Press, vol. 29(3), pages 335-47, December.
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