Illusion-Free Demand Behavior in a Monetary Economy: The General Conditions

Abstract

In monetary models the link between micro-foundations and macro-analysis, as it relates to demand behavior that is free of money illusion, is less than straightforward. If one assumes that an individual agent maximizes the usual neoclassical-type utility function, which contains consumption commodities exclusively as arguments, then the resulting commodity demand functions are homogeneous of degree zero in prices, initial money holdings and income; aggregation problems aside, it is therefore not unreasonable to assume that the aggregate market demand curves also exhibit this property. However, if one focuses on a monetary economy, and allows real balances to generally enter the agent’s objective function, then the resulting commodity demand functions are not homogeneous of degree zero; demand behavior does exhibit money illusion. In this type of monetary model, employed in various versions by Dusansky-Kalman and Grandmont, among others, the assumption of the absence of money illusion in aggregate demand behavior needs careful justification; it becomes necessary to impose further restrictions on the underlying miro-monetary framework. This paper reconsiders the microeconomic foundations of money illusion in a monetary neoclassical model which incorporates a generalized real balance effect into the utility function, and presents new results.