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

Suleyman Basak and Hongjun Yan

No 7398, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 (search for similar items in EconPapers)
JEL-codes: C60 D50 D90 G12 (search for similar items in EconPapers)
Date: 2009-08
New Economics Papers: this item is included in nep-mac and nep-mon
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Citations: View citations in EconPapers (3)

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Journal Article: Equilibrium Asset Prices and Investor Behaviour in the Presence of Money Illusion (2010)
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