Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion

34 Pages Posted: 8 Sep 2009

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Hongjun Yan

DePaul University

Multiple version iconThere are 3 versions of this paper

Date Written: August 2009

Abstract

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.

Keywords: Asset Pricing, Bounded Rationality, Equilibrium, Expected Inflation, Money Illusion, New Keynesian

JEL Classification: C60, D50, D90, G12

Suggested Citation

Basak, Suleyman and Yan, Hongjun, Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion (August 2009). CEPR Discussion Paper No. DP7398. Available at SSRN: https://ssrn.com/abstract=1469877

Suleyman Basak (Contact Author)

London Business School ( email )

Sussex Place
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HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Hongjun Yan

DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/view/hongjunyan

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