Compounding Money and Nominal Price Illusions

We develop a general equilibrium model in which investors simultaneously experience money and nominal price illusions. We show that the combined effects of these illusions widen the gap between the elasticities of the earnings yield of low- and high-priced stocks relative to the nominal interest rate. Empirically, we show that the compounded effects of money and nominal price illusions are stronger for low-priced stocks during periods of high inflation and economic downturns and for stocks with low institutional ownership. Our findings are robust when controlling for valuation uncertainties of low-priced stocks, including idiosyncratic volatility and firm age. This paper was accepted by Agostino Capponi, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.03549 .