MONEY ILLUSION AND MARKET SURVIVAL

By studying complete and incomplete dynamic financial markets, I show that if some agents are money-illusioned and neglect inflation, the rational agents who are aware of inflation are driven out of the market in the long run, in the sense that the money-illusioned agents consume the economy's entire endowment. The reason for this finding is that with inflation, the money-illusioned agents always believe that the return on their savings is higher than it actually is. Because these agents trade financial assets in markets with the rational agents, the rational agents end up being borrowers and the money-illusioned agents lenders. Because the rational agents' debt accumulates over time, they become so indebted that the money-illusioned agents eventually consume the economy's entire endowment. If there is deflation, the opposite is true, and the rational agents evolutionarily dominate.