Monetary Policy and Economic Growth under Money Illusion∗

Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into two stochastic continuous-time monetary models of endogenous growth. Motivated by psychology, we model an agent’s money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent’s perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is second order, whereas its impact on long-run growth is first order relative to the degree of money illusion. Monetary policy can eliminate this cost by correcting the distortions on a moneyillusioned agent’s consumption/savings decisions.