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Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion: A Preference-Based Formulation

Suleyman Basak

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

Hongjun Yan

Driehaus College of Business, DePaul University

October 2007

EFA Meetings, WFA Meetings

This article analyzes the implications of money illusion for investor behavior and asset prices in a securities market economy with inflationary fluctuations. Money illusion is modeled as an investor's partial overlooking the impact of inflation on the purchasing power of currency in his intertemporal decision making. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its utility 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 for relative risk aversion higher than unity. 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 and to a monetary economy with endogenous inflation.

Number of Pages in PDF File: 35

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

JEL Classification: C60, D50, D90, G12

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Date posted: November 29, 2004 ; Last revised: August 15, 2008

Suggested Citation

Basak, Suleyman and Yan, Hongjun, Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion: A Preference-Based Formulation (October 2007). EFA Meetings, WFA Meetings. Available at SSRN: https://ssrn.com/abstract=623561 or http://dx.doi.org/10.2139/ssrn.623561

Contact Information

Suleyman Basak (Contact Author)
London Business School ( email )
Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
44 (0)20 7000 8256 (Phone)
44 (0)20 7000 8201 (Fax)
HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
Hongjun Yan
Driehaus College of Business, DePaul University ( email )
1 East Jackson Blvd.
Chicago, IL 60604
United States
HOME PAGE: http://sites.google.com/site/hongjunyanhomepage/
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