Money illusion Jean-Robert Tyran U Vienna Outline Introduction - - PowerPoint PPT Presentation

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Money illusion Jean-Robert Tyran U Vienna Outline Introduction - - PowerPoint PPT Presentation

Jun 19, 2023 440 likes •806 views

The Econom ics of Money illusion Jean-Robert Tyran U Vienna Outline Introduction Evidence Surveys (Stephens and Tyran WP 2012) Neuroscience Field (labor, housing, stock markets ) Tyran (Science 2007), Fehr and

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The Econom ics of

Money illusion

Jean-Robert Tyran U Vienna

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  • Introduction
  • Evidence
  • Surveys (Stephens and Tyran WP 2012)
  • Neuroscience
  • Field (labor, housing, stock markets)
  • Tyran (Science 2007), Fehr and Tyran (JEP 2005)
  • Experiments
  • Fehr and Tyran (Games 2007): Long-run effects?
  • Fehr and Tyran (AER 2001): Nominal inertia?
  • Fehr and Tyran (ECMA 2008): Strategic properties?
  • Noussair, Richter and Tyran (JBF 2012): Asset market

bubbles?

  • Let‘s start with an analogy

Outline

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Which segment of the line is longer?

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Framing (length) (Müller-Lyer illusion, 1899)

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The Economics of Money illusion

What is it?

  • Thinking in money terms is salient, simple, natural

and often a good heuristic

  • People can overcome the “impulse” but it requires

cognitive effort

  • “rational expectations revolution”

(no evidence, on “a priori” grounds)

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Shafir, Tversky, Diamond (1997, QJE)

  • Questionnaire study
  • Example: 2% wage cut at no inflation is worse

than 2% wage increase at 4% inflation

  • Interaction of loss aversion and nominal thinking
  • Money Illusion as a framing effect

Shafir, Tversky and Diamond (QJE 1997)

Evidence: Surveys

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  • 732 respondents evaluate hypothetical housing

transactions (internet experiment). 4 real scenarios framed as nominal loss or gain (8Qs). Example (real loss of 2%):

  • “Albert bought a house for kr. 2’000’000. Some years

later he sells the house again.

  • Gain: In the period he owned the house, inflation was

11%, meaning that all prices increased by 11% during this period. Albert received kr. 2’175’600 for the house (i.e. 8 .8 % m ore than he paid).

  • Loss: In the period he owned the house, inflation was

1%, meaning that all prices increased by 1% during this period. Albert received kr. 1’979’600 for the house (i.e. 1 % less) than he paid).

  • How advantageous do you think this transaction was?”

(Scale 1-15)

Tyran and Stephens (WP 2012)

Evidence: Surveys

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  • 73% of respondents have NLA > 0
  • Lower NLA scores for those who think longer,

have higher IQ and cognitive reflection scores

Tyran and Stephens (WP 2012)

Evidence: Surveys

IQ scores

Index of NLAi: response in gain frame – loss frame (averaged). NLA > 0: worse evaluation when nominal loss

5 10 15

Percentage (N = 732)

  • 15
  • 10
  • 5

5 10 15

Nominal loss aversion index

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  • “medial prefrontal cortex exhibits money

illusion”: earn money to shop from a catalogue. Treatments: Low vs. high (money earned and prices are 50% higher)

  • mPFC has been associated with processing of

rewards

  • Money illusion as measured in the mPFC is

correlated with questionnaires

  • Advantage: Money illusion

is directly observed

  • Limitation: no interaction

Weber, Rangel, Wibral and Falk (PNAS 2009)

Evidence: Neuroeconomics

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  • Labor Markets
  • Fehr and Goette (JME 2005)
  • Low inflation rates are costly (because nom. wages

cannot adjust to sectoral shocks)

  • Asymmetric real effects of monetary policy: large with

contraction, small with expansion

The Economics of Money illusion

Evidence: Field studies

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  • Housing markets
  • Genesove and Mayer (QJE 2001)
  • Brunnermeier and Juillard (RFS 2008)
  • Asset markets
  • Modigliani and Cohn (Fin.Analyst 1979), Cohen, Polk, Voulteenaho

(QJE 2005), Schmeling and Schrimpf (EER 2011)

  • Limitation: Can alternative explanations be ruled out?

The Economics of Money illusion

Evidence: Field studies

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  • Lab Experiments
  • Fehr and Tyran (Games 2007): Long-run effects?
  • Fehr and Tyran (AER 2001): Nominal inertia? Asymmetry?
  • Fehr and Tyran (ECMA 2008): Strategic properties?
  • Noussair, Richter and Tyran (WP 2008): Asset market

bubbles?

  • Advantage: isolate causal factors due to experimental

control

  • Limitation: Did the experiment capture the important

features of the “natural” economy?

The Economics of Money illusion

Experiments

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  • Intuition: Money illusion has
  • direct effects: bias, errors in optimization
  • indirect effects: people expecting that others

make biased decisions react strategically

  • Indirect effects are large if strategic

com plem entarity prevails: “Incentive to follow the crowd”

  • Indirect effects operate through expectations

The Economics of Money illusion

Experiments

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average price of others Your price

45-degree line

Equilibria are pareto-rankable A > C in real terms but A < C in nominal terms Money illusion may coordinate expectations on an inefficient equilibrium: permanent losses

A C

Money illusion and Coordination failure (Fehr and Tyran, GEB 2007)

Basic idea of the design Equilibrium selection problem

Idea: MI as a coordination device

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  • Participants are in the role of firms, choose price

from 1 to 30, indicate price expectation

  • 30 periods, groups of n = 5 or 6, in total 174

subjects

  • 2 treatments: nominal vs. real representation of

payoffs

  • Feedback: real payoff, actual average price

Money illusion and Coordination failure (Fehr and Tyran, GEB 2007)

Experimental design

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All groups in NH

converge to the inefficient equilibrium (C),

all groups in RH to

the efficient equilibrium (A). Average profit in NH is about half of RH (53%)

  • Money illusion:

Coordination on inefficient equilibrium

Money illusion and Coordination failure (Fehr and Tyran, GEB 2007)

Average prices

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Nominal (n = 77) Real (n = 52)

C B A

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Expectations in NH are much higher than in RH from the beginning Prices track expectations very

  • well. Most subjects

choose best replies to expectations.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Expectation NH Expectation RH

Money illusion and Coordination failure (Fehr and Tyran, GEB 2007)

Role of Expectations

A B C

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In individual decision making, most (82%) learn to overcome money illusion by the last period

 I ndirect effect is important

Money illusion and Coordination failure (Fehr and Tyran, GEB 2007)

Direct vs. indirect effects

NH NC Equilibrium A

0.00 0.82

Equilibrium C

0.84 0.18

  • Direct or indirect effect?
  • Idea: eliminate the need to form expectations by

transforming game into individual optimization problem: treatments with computerized opponents

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Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Experimental Design

  • Does money illusion cause nominal inertia?

Fehr and Tyran (AER 2001)

  • Main differences to Fehr and Tyran (GEB 2007):
  • Game with a unique equilibrium
  • Monetary shock
  • Payoff functions are homogenous of degree 0
  • Negative shock
  • No exogenous frictions whatsoever
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Average price of others Your price

45-degree line

Unique equilibrium

A

Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Intuition

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Average price of others Your price

45-degree line

If common knowledge of rationality: immediate adjustment to C

A C

Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Intuition

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Average price of others Your price

45-degree line

If common knowledge of rationality: immediate adjustment to C If expectations are sticky:

nominal inertia

A C

Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Intuition

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Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Average nominal prices

Source: Fehr and Tyran (AER, 2001)

5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

  • 20
  • 18
  • 16
  • 14
  • 12
  • 10
  • 8
  • 6
  • 4
  • 2

1 3 5 7 9 11 13 15 17 19

Real RH Nominal NH Pre-shock phase

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Money illusion and nominal inertia (Fehr and Tyran, AER 2001)

Expectations Why are nominal prices sticky?

  • Nominal frame induces

sticky expectations

  • Why are expectations

sticky? Nominal loss aversion

  • Test: positive shock
  • We find strong

asymmetry: quick adjustment of prices after positive shock

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Money illusion and nominal inertia (Fehr and Tyran, ECMA 2008)

Complements vs. Substitutes Does strategic com plem entarity cause nom inal inertia? Idea:

  • Strategic complements: rational players have an

incentive to imitate irrational players  multiply

  • Strategic substitutes: rational players have an incentive

to compensate the behavior of irrational players  mitigate

  • Same procedures as with “negative shock”.
  • Treatments:

Change slope of reaction function (ceteris-paribus variation)

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Money illusion and nominal inertia (Fehr and Tyran, ECMA 2008)

Nominal average prices

10 12 14 16 18 20 22 24 26

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Complements (NH) Substitutes (NH)

Average price

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28

How relevant are strategic complements?

  • Pricing in oligopolistic markets
  • Pricing in asset markets can be characterized by

endogenous complementarity (“momentum”)

  • Complementarity between wages and prices
  • Neg. shock  nominal wages fall little  nominal

prices fall little  nominal wages fall little

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Noussair, Richter and Tyran (JBF 2012)

Money illusion and asset market bubbles

  • Effect of money illusion in an asset market? (double

auction)

  • Market with constant fundamental value. Dividend-

bearing asset has E(D) = 0 in all periods

  • Participants are endowed with 5 units of the asset and

cash worth DKK 250 each but everything (except for the terminal value of the asset, 10 DKK) was denoted in “ECU”

  • After some periods, we implement a purely nominal

shock, by re-scaling all nominal values by k. If k > 1: “inflation”, if k < 1: “deflation” (and control with k = 1)

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Noussair, Richter and Tyran (JBF 2012)

Money illusion and asset market bubbles

  • Pre-shock phase: Markets bubble, but independent
  • f level of nominal value: no “numerosity” effect
  • real price = nominal price / k

800 1000 1200 1400 1600 1800 2000 2200 2400 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 real average price of median market period Control Deflation Inflation pre-shock phase post-shock phase fundamental value

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Noussair, Richter and Tyran (JBF 2012)

Money illusion and asset market bubbles

  • Post-shock phase: Deflation: bubble is exacerbated:

money illusion affects bubbles

  • Our explanation: nominal loss aversion

800 1000 1200 1400 1600 1800 2000 2200 2400 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 real average price of median market period Control Deflation Inflation pre-shock phase post-shock phase fundamental value

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The economics of money illusion

Conclusions

  • Money illusion
  • Thinking in nominal values is natural, salient. It is

an “impulse” like optical illusions, is common (in surveys) and can be measured in the reward system of the brain, but can be avoided with cognitive effort

  • Money illusion interacts with loss aversion: nominal

losses are more salient

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The economics of money illusion

Conclusions

  • Experimental evidence
  • Can have long-term effects by coordinating agents on

bad equilibrium

  • Asymmetric effects: Strong nominal inertia after negative

monetary shock, little effect after positive

  • Money illusion shapes expectations formation
  • Almost no inertia with S. Substitutes
  • Asset market bubble not affected by level of nominal

scale but is affected by change of scale (nominal loss aversion)

Together with field evidence from labor, real estate and asset markets, this suggests that money illusion belongs on economists’ research agenda

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The organizer’s question

  • Can economics as a scientific discipline benefit from

concepts, methods and insights developed in other disciplines, notably the natural sciences?

  • Yes
  • Incorporate concepts & insights from psychology: Loss

aversion, (money) illusion/perception, cognition

  • Adapt methods from social science (surveys) and from

natural science: neuroeconomic, experimental