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In principle, money illusion could explain the inertial adjustment of prices after changes of monetary policy. Hence, money illusion could provide an explanation of monetary non-neutrality. However, this explanation has been thoroughly discredited in modern economics. As a consequence, economists have ever since the 1970s searched for alternative explanations for nominal rigidity. These explanations are all based on the assumption of fully rational economic agents, holding rational expectations. This book argues that money illusion has been prematurely dismissed as an explanation of monetary non-neutrality. Methods of experimental economics are used to investigate the real aggregate effects of money illusion. It is shown that money illusion in fact causes (short-run) real income effects if strategic complementarity prevails. Strategic complementarity is an important characteristic of naturally occurring macroeconomies and is a recurrent theme in most models explaining nominal rigidity.

Inhaltsverzeichnis

Frontmatter

Introduction

Introduction

Abstract
Why can changes in monetary policy cause fluctuations in employment and production? This has been one of the most important and most intensely debated questions in economics ever since David Hume’s (1752) contributions. The issue of monetary non-neutrality is important because the misconduct of monetary policy may create enormous damage to the real economy and thereby affect the economic lives of millions of people. For example, abrupt and massive reductions in the quantity of money are claimed to have been responsible for severe depressions like the Great Depression in the 1930s or the 1982 recession in the United States. Thus, investigating the causes of monetary non-neutrality is important because it may help avoid misconduct in monetary policy. Despite the immense amount of theoretical and empirical research that has been produced in the last two centuries, the issue remains intensely debated for two reasons. First, it is difficult to identify and accurately measure the variables of interest. For example, the quantity of money is a concept which is not easily defined, and the price level is difficult to measure. In addition, presumed causalities are hard to establish by analyzing field data since many (unobservable) variables may change simultaneously. The second reason why the question of monetary neutrality remains controversial is of methodological nature. Economists have established a firm tradition to approach the issue of monetary (non-) neutrality by assuming that all economic agents are fully rational and form rational expectations. This assumption has kept its strong position up to the day. Hence, money illusion has been dismissed as an explanation of monetary non-neutrality on a priori grounds.
Jean-Robert Tyran

Approaches to the Problem of Monetary Non-Neutrality

Frontmatter

Chapter 1. Empirical evidence on the non-neutrality of money from macroeconomic data

Abstract
This chapter provides a very brief survey of the empirical literature investigating monetary neutrality using macroeconomic time-series data. The main purpose of this chapter is to show that the issue of monetary non-neutrality is controversial and to provide some explanations for this state of affairs.
Jean-Robert Tyran

Chapter 2. Theories of nominal rigidity and monetary non-neutrality

Abstract
This chapter presents a short overview of theories of monetary non-neutrality which rest on the assumption that monetary non-neutrality arises because nominal prices do not adjust immediately after a monetary shock.9
Jean-Robert Tyran

Chapter 3. 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).
Jean-Robert Tyran

Chapter 4. Why can money illusion and strategic complementarity cause monetary non-neutrality?

Abstract
This chapter explains the theoretical background of the present study. It serves the purpose of formulating the alternative hypotheses summarized in section 5.2. Section A) explains the intuition behind the theoretical argument by Haltiwanger and Waldman (1985, 1989). These authors show that, when agents are heterogeneous with respect to rationality, boundedly rational agents may have a disproportionately large impact on the aggregate if strategic complementarity prevails. This intuition has come to the minds of several authors (e.g. Leuonhufvud, 1981) within various contexts but will be discussed here only in the context of monetary non-neutrality. Section B) explains in what respect money illusion may be source of bounded rationality. In particular, the interaction of beliefs about others’ money illusion and strategic properties is discussed.
Jean-Robert Tyran

Chapter 5. Summary of part I and hypotheses

Abstract
Section 5.1. summarizes Part I and section 5.2 summarizes the hypotheses of the experimental study.
Jean-Robert Tyran

Experimental Study

Frontmatter

Chapter 1. Are experiments in macroeconomics possible?

Abstract
This chapter discusses whether experimentation in economics, and in particular in macroeconomics is possible and useful. Sections A) and B) provide a general introduction which draws heavily on Falk and Tyran (1997). Section C) explains that macroeconomics should be viewed as an indirectly experimental science and briefly summarizes the small existing experimental literature on (monetary) macroeconomics.
Jean-Robert Tyran

Chapter 2. Experimental design to isolate causes of monetary non-neutrality

Abstract
This chapter presents an experimental design which allows to implement an anticipated monetary shock and to observe nominal as well as real variables (and, thus, monetary (non-)neutrality). The discussion proceeds as follows: Section 2.1. provides a general description of the design. Section 2.2. explains procedures and parameters. Section 2.3. describes the treatments in detail. Section 2.4. mentions advantages of the experimental design in the investigation of monetary non-neutrality.
Jean-Robert Tyran

Results of Experimental Study

Frontmatter

Chapter 1. Non-neutrality with strategic complementarity

Abstract
According to the Neutrality hypothesis H0 anticipated monetary shocks do not affect real economic activity in the absence of exogenous of informational frictions. This should hold irrespective of framing and irrespective of the strategic property of the environment. According to this hypothesis anticipated money should be neutral in all cells of table 3. This chapter shows that a fully anticipated monetary shock is massively short-run non-neutral when the environment is represented in nominal terms and strategic complementarity prevails (see shaded cell NTC in table 3). Thus, the Neutrality hypothesis H0 is rejected. Yet, the proposition of long-run neutrality is supported by the data. Individual level data on price expectations, best reply behavior and a profit decomposition show that short-run non-neutrality mainly arises because of non-rational expectations and strategic interaction, whereas individually irrational behavior is of relatively minor importance.
Jean-Robert Tyran

Chapter 2. Does money illusion matter?

Abstract
This chapter investigates whether money illusion is a cause of nominal rigidity and monetary non-neutrality.
Jean-Robert Tyran

Chapter 3. The effects of strategic complements and strategic substitutes

Abstract
This chapter investigates whether strategic complementarity is a cause of nominal rigidity and monetary non-neutrality.
Jean-Robert Tyran

Chapter 4. Summary of results

Abstract
Chapter 1 discussed the effects of an exogenous, anticipated money shock when the environment is characterized by strategic complements and is represented in nominal terms (NTC). According to the Neutrality hypothesis H0, an anticipated money shock should be neutral irrespective of the representation or the strategic properties of the economic environment. This hypothesis is clearly rejected. Aggregate-level data show that an anticipated monetary shock causes massive nominal rigidity (see result R1) and monetary non-neutrality (R2): Average nominal prices only adjust to the new equilibrium level after 12 periods, and average efficiency losses are large in the first few periods before the shock (−65% impact effect). The results provide support for the notion of short-run non-neutrality of anticipated monetary shocks, but also for long- run neutrality of money since aggregate behavior eventually converges to the predicted equilibrium (R3). Individual-level data show that subjects behave very rationally given their expectations (R4). Most importantly, price expectations are sticky and are much less correct after the shock (R5). These findings allowed the formulation of a first tentative explanation of the causes of monetary non-neutrality (R6): because expectations were sticky (i.e. subjects expected other subjects to adjust nominal prices only a little) and because subjects chose best replies to their expectations, sticky expectations lead to sticky nominal price choices given strategic complementarity. This downward nominal rigidity translates into real income losses. The loss decomposition supports this explanation. It shows that the efficiency losses mainly result because subjects hold wrong expectations about aggregate price behavior (R7). Consequently, subjects are less confident in their ability to predict the price level. The announcement of the anticipated monetary shock seems to have fundamentally shaken the process of expectation formation (R8).
Jean-Robert Tyran

Discussion of Results

Frontmatter

Chapter 1. Empirical relevance of results

Abstract
A prominent experimentalist recently criticized that experiments are sometimes abused to demonstrate “pseudo-anomalies“ (see quotation above). The author pointed out that observed behavior may very much depend on the specifics of an experimental design and its procedures. In particular, Friedman (1998: 941) states that “Every choice anomaly can be greatly diminished or entirely eliminated in appropriately structured learning environments.“ We completely agree with this assertion. In fact, this study provides an example for this statement. We have identified conditions (strategic substitutes) under which the “choice anomaly“ of money illusion does not considerably affect aggregate behavior. Controlled variations of the decision environment allowed the identification of other conditions (i.e. strategic complements) under which money illusion does have massive effects on aggregate real income. The experimental method therefore allowed the isolation of money illusion and strategic complementarity as causes of monetary non-neutrality. We suggested that the experimental results are highly relevant because strategic complementarity and the use of money are very natural features in actual macroeconomies. However, one may claim that the results are in some sense biased because all treatment conditions create an environment which is favorable to the finding of monetary neutrality, i.e. against the finding that money illusion matters. Such biases arise if the design deviates in important respects from naturally occurring economies. Since we consider this criticism to be important, this chapter takes another look at the specifics of the design and the procedures with respect to external validity of the findings (see also Part II, chapter 2).
Jean-Robert Tyran

Chapter 2. Implications for economic theory and policy

Abstract
This study has shown that money illusion and strategic complementarity are causes of nominal rigidity and monetary non-neutrality. This finding brings up a difficult issue: if the rational-agent paradigm fails to predict behavior in this case, should we give up rational-agent theory? Section 2.1. explains why the traditional answer to this question has been negative. It is argued that a more differentiated answer could be productive. Section 2.2. specifies what providing a “differentiated“ attitude to rationality issues implies for macroeconomic theory. Section 2.3. draws some tentative conclusions for economic policy.
Jean-Robert Tyran

Backmatter

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