Limited Rationality and Strategic Interaction - the Impact of the Strategic Environment on Nominal Inertia

Abstract:     
The evidence from many experiments suggests that people are heterogeneous with regard to their abilities to make rational, forward looking, decisions. This raises the question when the rational types are decisive for aggregate outcomes and when the boundedly rational types shape aggregate results. We examine this question in the context of a long-standing and important economic problem - the adjustment of nominal prices after an anticipated money shock. Our experiments show that when agents' actions are strategic substitutes adjustment to the new equilibrium is extremely quick whereas under strategic complementarity adjustment lasts very long and is associated with relatively large real effects. This adjustment difference occurs because price expectations are very flexible under substitutability and very sticky under complementarity. Our results suggest that strategic complementarity does not only provide incentives for the rational types to partly mimic the behavior of the boundedly rational types but it also renders people less rational and forward looking. In addition, under complementarity people attribute less rationality to the other players.

JEL Classifications: C92, E31, E52

Accepted Paper Series