published in: Games and Economic Behavior, 2007, 59 (2), 246-268
Economists long considered money illusion to be largely irrelevant. Here we show, however,
that money illusion has powerful effects on equilibrium selection. If we represent payoffs in
nominal terms, choices converge to the Pareto inefficient equilibrium; however, if we lift the
veil of money by representing payoffs in real terms, the Pareto efficient equilibrium is
selected. We also show that strategic uncertainty about the other players’ behavior is key for
the equilibrium selection effects of money illusion: even though money illusion vanishes over
time if subjects are given learning opportunities in the context of an individual optimization
problem, powerful and persistent effects of money illusion are found when strategic
uncertainty prevails.
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