Money illusion

Abstract

In principle, money illusion could provide an explanation for the inertia of nominal prices and wages and, thus, for the non-neutrality of money. The stickiness of nominal prices and wages seems to be an important phenomenon (see section 3.2.B) and has puzzled economists for decades because it is quite difficult to explain in an equilibrium model with maximizing individuals. Yet, the notion of money illusion seems to be thoroughly discredited in modern economics. Tobin (1972), for example, described the negative attitude of most economic theorists towards money illusion as follows: “An economic theorist can, of course, commit no greater crime than to assume money illusion.“ As a consequence of this negative attitude, money illusion is anathema in mainstream economics. For example, the index of the handbook of monetary economics (Friedman and Hahn, 1990) does not even mention the term “money illusion“. Instead of referring to a concept so alien to mainstream economics, researchers have sought for explanations which are based on rational agents holding rational expectations. Factors like informational frictions, costs of price adjustment and staggering of contracts have been invoked to explain nominal inertia (see chapter 2.2.). The present study does not contest the potential relevance of these explanations. However, it is argued that money illusion has been prematurely dismissed as a potential candidate for the explanation of sluggish nominal price adjustment. Our argument is based on theoretical considerations and on empirical evidence. At the theoretical level it will be argued that in order to rule out the relevance of money illusion it is not sufficient that individuals are illusion-free but that the absence of money illusion is common knowledge (see chapter 4).