Monetary Policy and Economic Growth Under Money Illusion

40 Pages Posted: 16 Oct 2007

See all articles by Danyang Xie

Danyang Xie

Hong Kong University of Science & Technology (HKUST) - Department of Economics

Jianjun Miao

Boston University - Department of Economics

Date Written: October 2007

Abstract

Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into two stochastic continuous-time monetary models of endogenous growth. Motivated by psychology, we model an agent's money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent's perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is second order, whereas its impact on long-run growth is first order relative to the degree of money illusion. A monetary policy can eliminate this cost by correcting the distortions on a money-illusioned agent's consumption/savings decisions.

Keywords: money illusion, inflation, growth, welfare cost, behavioral macroeconomics

JEL Classification: D92, E21, E31, E52

Suggested Citation

Xie, Danyang and Miao, Jianjun, Monetary Policy and Economic Growth Under Money Illusion (October 2007). Available at SSRN: https://ssrn.com/abstract=1021921 or http://dx.doi.org/10.2139/ssrn.1021921

Danyang Xie

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
852-2358-7603 (Phone)
852-2358-2084 (Fax)

Jianjun Miao (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)

HOME PAGE: http://people.bu.edu/miaoj

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