How money illusions and heterogeneous beliefs affect asset prices

Abstract

We develop a dynamic asset pricing model with two investors with money illusions and heterogeneous beliefs about some aspects of the economy. The model is tractable and delivers closed forms for all equilibrium quantities. The study shows that money illusion leads the nominal shock risk to generate spillover effects on the real side of the economy and affects all equilibrium quantities, even without inflation disagreement. We find that bond yields increase, but the stock price decreases, as money illusion increases. Bond yield and stock price volatilities increase with fundamental disagreement, while the latter decreases with inflation disagreement. We also discover that the stock risk premium is inverse-U shaped as inflation disagreement increases. Moreover, we find that the optimistic investor holds positions in real bonds and stocks, and shorts the nominal bond to hedge against the risk of market changes, which is in line with the pessimistic investor’s beliefs.