Monetary Policy and Economic Growth under Money Illusion

Jianjun Miao and Danyang Xie

No wp2007-045, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into two stochastic continuous-time monetary models of endogenous growth. Motivated by psychology, we model an agent's money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent's perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is second order, whereas its impact on long-run growth is first order relative to the degree of money illusion. Monetary policy can eliminate this cost by correcting the distortions on a money-illusioned agent's consumption/savings decisions.

Keywords: money illusion; inflation; growth; welfare cost; behavioral macroeconomics (search for similar items in EconPapers)
JEL-codes: D92 E21 E31 E52 (search for similar items in EconPapers)
Pages: 40
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Citations: View citations in EconPapers (3)

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