The Role of Money Illusion in Nominal Price Adjustment

Our experiments refine and extend the work of Fehr and Tyran (2001), who suggest that money illusion can contribute significantly to nominal inertia in strategically complementary environments. By controlling for strategic uncertainty, visual focal points and cognitive load we find that participants exhibit no first order money illusion, though second order money illusion plays a minor role. The presence of a focal point in our experiments reduces the duration of price stickiness compared to FT’s original experiments when participants played against one another. What stickiness remains is explained by the difficulty of finding the NE among 1800 payoffs. Second order money illusion appears to explain the persistent asymmetry between price adjustment following positive and negative monetary shocks. However, this is a modest effect manifested in an apparent preference for (aversion to) high (low) nominal payoffs within a set of maximum real payoffs. These findings indicate that FT’s proposed form of money illusion is not a compelling explanation for sluggish price adjustment.