Money Illusion and Coordination Failure
University of Zurich - Department of Economics
University of Vienna; University of Copenhagen - Department of Economics; Centre for Economic Policy Research (CEPR)
February 1, 2004
IZA Discussion Paper No. 1013; CESifo Working Paper Series No. 1141; Zurich IEER Working Paper No. 177
Games and Economic Behavior, Vol. 58, No. 2, 2007
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.
Number of Pages in PDF File: 35
Keywords: money illusion, coordination failure, equilibrium selection, multiple equilibria, coordination games
JEL Classification: C9, E32, E52
Date posted: February 5, 2004 ; Last revised: May 10, 2013
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