We show that when investors suffer from endogenous asymmetric money illusion, the usual proportionality between money supply and nominal prices commonly present in frictionless economies is eliminated. This drives changes in the money supply to cause real price fluctuations. Nevertheless, the combined effect on the real state price density and the price of money leads the nominal state price density, and consequently nominal bond prices, to be independent of money illusion. This article thus provides a theoretical foundation for Modigliani-Cohn’s conjecture that money illusion impacts stock markets but
In the treatments of joint liability-based loans, each subject was randomly matched with a borrowing partner, and the pair (or group) was collectively responsible for repaying TK120. A subject whose project failed could not repay. A subject with a successful project either contributed to group-repayment or decided not to contribute. If both subjects repaid, the experimenter collected TK60 from each of them. If only one member of the group repaid, the experimenter collected TK120 from the contributing member. Thus, at least one member had to repay to fulfill the group-repayment obligation. The third treatment of the game was joint liability loans without dynamic incentives. In this treatment, both members of a group received repeat loans at the end of a loan cycle irrespective of their repayment decisions. The fourth treatment was joint liability loans with dynamic incentives. In this treatment, subjects received repeat loans only if the group-repayment obligation had been fulfilled; otherwise, the game ended for the group. To operationalize the treatments of joint liability loans, we took each pair at a time to a private room, where subjects played the ball-drawing game and made repayment decisions. Thus, a subject’s project outcome and repayment decision were observed by her/his partner.5 Special care was taken so that both of the subjects revealed their repayment decisions simultaneously (see Appendix B for experimental instructions of the loan repayment game). We did not allow subjects to communicate with each other.
A potential concern with the loan repayment game is that in treatments with dynamic incentives, subjects’ repayment decision may deteriorate toward the end of the experiments if they know the end point of the game (see, for example, Cassar et al., 2007). It is thus important to conduct these treatments without a predetermined end point. Following this intuition, and in order to be consistent across all the treatments of the loan repayment game, we conducted all four treatments without a predetermined end point. Specifically, after the third round of play, we continued the game only with a probability of one-half. A coin was tossed by the experimenter to determine whether to continue, but subjects were never informed of this not bond markets.