Econometrica: Mar 2008, Volume 76, Issue 2

Limited Rationality and Strategic Interaction: The Impact of the Strategic Environment on Nominal Inertia

https://doi.org/10.1111/j.1468-0262.2008.00836.x
p. 353-394

Ernst Fehr, Jean‐Robert Tyran

Much evidence suggests that people are heterogeneous with regard to their abilities to make rational, forward‐looking decisions. This raises the question as to when the rational types are decisive for aggregate outcomes and when the boundedly rational types shape aggregate results. We examine this question in the context of a long‐standing and important economic problem: the adjustment of nominal prices after an anticipated monetary shock. Our experiments suggest that two types of bounded rationality—money illusion and anchoring—are important behavioral forces behind nominal inertia. However, depending on the strategic environment, bounded rationality has vastly different effects on aggregate price adjustment. If agents' actions are strategic substitutes, adjustment to the new equilibrium is extremely quick, whereas under strategic complementarity, adjustment is both very slow and associated with relatively large real effects. This adjustment difference is driven by price expectations, which are very flexible and forward‐looking under substitutability but adaptive and sticky under complementarity. Moreover, subjects' expectations are also considerably more rational under substitutability.

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Supplemental Material

Supplement to "Limited Rationality and Strategic Interaction - The Impact of the Strategic Environment on Nominal Inertia"

Contains a translation of the original instructions (from German), plus tables C1-C4 and D1-D4, and the dataset used in paper.  The file also contains full set of payoff tables, instructions, and programs for all 4 control treatments.  In addition, a script for experimenters is added.  An overview of the supplementary materials is also provided.

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