35 Pages Posted: 5 Feb 2004 Last revised: 10 May 2013
Date Written: February 1, 2004
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.
Keywords: money illusion, coordination failure, equilibrium selection, multiple equilibria, coordination games
JEL Classification: C9, E32, E52
Suggested Citation: Suggested Citation
Fehr, Ernst and Tyran, Jean-Robert, Money Illusion and Coordination Failure (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. Available at SSRN: https://ssrn.com/abstract=495402 or http://dx.doi.org/10.2139/ssrn.495402