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

Authors

  • Ernst Fehr,

    1. Institute for Empirical Research in Economics, University of Zurich, Bluemlisalpstrasse 10, CH-8006 Zurich, Switzerland, and Collegium Helveticum, CH-8092 Zürich, Switzerland; efehr@iew.uzh.ch
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  • Jean-Robert Tyran

    1. Dept. of Economics, University of Copenhagen, Studiestræde 6, DK-1455 Copenhagen K, Denmark; jean-robert.tyran@econ.ku.dk
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    • We thank three anonymous referees for their insightful comments and suggestions that helped us to improve the paper. We also acknowledge helpful comments from participants of seminars at Harvard University, Princeton University, the Stockholm School of Economics, the Swiss National Bank (Zurich), the Center for Financial Studies and the Bundesbank (Frankfurt), the Econometric Society, and the Association of Swiss Economists. Valuable research assistance has been provided by Urs Fischbacher, Frederik Øvlisen, and Christian Thöni. Financial support from the National Center of Competence in Research on Financial Valuation and Risk Management is gratefully acknowledged. The National Centers in Research are managed by the Swiss National Science Foundation on behalf of the federal authorities.


Abstract

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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