Sunday, October 16, 2016: 11:55 AM
The existence of money illusion is disputed by monetary economists, especially due to the rational expectations hypothesis, which entails no possibility of money illusion. Nevertheless, its recent resurrection arrived with behavioral economics, which enables systematic deviation of individual behavior from rational expectation. Actually, there is clear evidence about the fact that people tend to think of the currency in nominal, rather than in real terms. Empirical study of Shafir, Diamond and Tversky, (1997) based on experimental survey investigating the effects of money illusion, speaks in favor of such a behavior. Money illusion effects were also proved experimentally at the aggregate level in study of Fehr and Tyran (2001). Although money illusion is largely dismissed by mainstream economics, there still remains a large scope for discussion of its suboptimal effects. One of many well-discussed issues is also Modigliani-Cohn hypothesis (1979), which argues that the stock market suffers from money illusion, where people tend to discount real cash flows at nominal discount rates. Also the effect of money illusion has consequences for pricing of risky stocks relative to safe stocks, as suggested by Cohen, Polk, Vuolteenaho (2005). The main aim of this paper will be to enrich contemporary theoretical underpinnings by discussion about relevance of money illusion for decision-making of subjects on financial markets and particularly its relevance with respect to Modigliani-Cohn hypothesis (1979) in a contemporary world. Attention will be paid to the ability of money illusion hypothesis to explain the volatility of mispricing in the stock market from standard, but also from experimental point of view. Discussion will be also devoted to Fisher’s effect, well-discussed in empirical literature, responsible for rather imperfect adjustment of the interest rate to expected inflation.
JEL Classification: B5, E5, E6, G10
Key Words: Money Illusion, Modigliani-Cohn Hypothesis, Fisher’s Effect, Stock Market