Lost in Conversion: Money Illusion and Corporate Investment

Abstract

We examine whether money illusion reaches the corporate allocation of capital. Our natural experiment is the European currency changeover, which rescaled firms' accounts at predetermined conversion rates that varied widely in nominal magnitude. We find that investment rises with the magnitude of the rescaling, controlling for the real channels of monetary union. A one-standarddeviation larger conversion rate corresponds to roughly 15% of mean investment. The gradient survives an exclusion design, a geographic regression discontinuity, and an instrumental variables design. The illusion enters through cash-flow projections in capital budgeting, strengthens with conversion complexity and anchor stability, and weakens with managerial experience. The evidence is consistent with managers anchoring on legacy-currency magnitudes in the new nominal frame.