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

Abstract

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.