lecture9 - Lecture IX Economics 202A Fall 2007 Today I am...

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1 Lecture IX Economics 202A Fall 2007 Today I am going to go over two articles. The first is by Fehr and Tyran, on Money Illusion. And the second is by Gregory Mankiw on small menu costs. It is another version of near rationality. I will go over that insofar as time permits. But I also want to discuss what is happening in the current economy. I will give an assessment, and then I thought we would open the question to class discussion. Fehr and Tyran have adapted the monopolistic competition model that we saw last time to use it as the basis for an experiment. The basic question is whether there is money illusion. And if there is money illusion, can we say something about its nature? I think that the conclusion from their article is that there is secondary money illusion, and that can be just as effective in changing equilibrium outcomes as primary money illusion. You will see what I mean by that. To begin, they construct an economy in which the Profits of individual i depend on: p i , p -i and M. where p i is the price charged by i, p -i is the vector of prices charged by everyone other than i. and M is the money supply. So that A i = A i (p i , p -i ,M). Real returns will be homogeneous of degree 0 in p i , p -i and M. A doubling of all prices and also of the money supply will leave all real returns totally unchanged. The framework is exactly the same as we saw last time.
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2 One starts off with an initial money supply: M 0 . Then one allows subjects to play the initial game for some time, which is for 10 or 20 rounds, until the prices chosen by the players converge to an equilibrium. Most importantly the average price level, p G converges to p G 0 * . Then change the money supply from M 0 to M 1 . And then see how rapidly the price level converges to its new long-run equilibrium. In the absence of money illusion it should converge immediately. There are two types of payoffs: real payoffs, which are denoted R, and nominal payoffs, which are denoted N. There are also two types of opponents: computer opponents, denoted C. and human opponents, denoted H. This gives Fehr and Tyran four variants of their experiment. 1. RC. In RC, the payoff functions are given to the subjects in real terms. And, in RC, the players are told that the other players will be a Computer. The computer will choose their prices to maximize their profits according to a rule. R stands for Real and C stands for Computer. 2. RH In RH the payoff functions are given in real terms. The players are told that other players are human. As before R stands for Real , but H stands for Human. 3. NC In NC the payoff functions are given in Nominal terms. The players are told that other players are a computer following a maximizing rule.
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3 4. NH In NH the payoffs are expressed in Nominal terms. This time, however, the other players are Human.
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lecture9 - Lecture IX Economics 202A Fall 2007 Today I am...

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