Money Illusion and Coordination Failure

35 Pages Posted: 5 Feb 2004 Last revised: 10 May 2013

Ernst Fehr

University of Zurich - Department of Economics

Jean-Robert Tyran

University of Vienna; University of Copenhagen - Department of Economics; Centre for Economic Policy Research (CEPR)

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Date Written: February 1, 2004

Abstract

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

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

Ernst Fehr (Contact Author)

University of Zurich - Department of Economics ( email )

Bl├╝mlisalpstrasse 10
Zuerich, 8006
Switzerland
+41 1 634 3709 (Phone)
+41 1 634 4907 (Fax)

Jean-Robert Tyran

University of Vienna ( email )

Oskar-Morgenstern-Platz 1
Vienna, Vienna 1090
Austria

HOME PAGE: http://homepage.univie.ac.at/jean-robert.tyran/

University of Copenhagen - Department of Economics ( email )

├śster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark
+45 353 23 027 (Phone)

HOME PAGE: http://www.econ.ku.dk/tyran/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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