Money illusion

In economics, money illusion, or price illusion, refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is false, as modern fiat currencies have no intrinsic value and their real value is derived from their ability to be exchanged for goods (purchasing power) and used for payment of taxes.

The term was coined by Irving Fisher in Stabilizing the Dollar. It was popularized by John Maynard Keynes in the early twentieth century, and Irving Fisher wrote an important book on the subject, The Money Illusion, in 1928.^[1] The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth.^[2] Eldar Shafir, Peter A. Diamond, and Amos Tversky (1997) have provided compelling^{[citation needed]} empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations.^[3]

Shafir et al.^[3] also state that money illusion influences economic behaviour in three main ways:

• Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
• Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
• Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.

Money illusion can also influence people's perceptions of outcomes. Experiments have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. However, this result is consistent with the 'Myopic Loss Aversion theory'.^[4] Furthermore, the money illusion means nominal changes in price can influence demand even if real prices have remained constant.^[5]

On the money illusion

Some have suggested that money illusion implies that the negative relationship between inflation and unemployment described by the Phillips curve might hold, contrary to recent macroeconomic theories such as the "expectations-augmented Phillips curve".^[6] If workers use their nominal wage as a reference point when evaluating wage offers, firms can keep real wages relatively lower in a period of high inflation as workers accept the seemingly high nominal wage increase. These lower real wages would allow firms to hire more workers in periods of high inflation.

Explanations of money illusion generally describe the phenomenon in terms of heuristics. Nominal prices provide a convenient rule of thumb for determining value and real prices are only calculated if they seem highly salient (e.g. in periods of hyperinflation or in long term contracts).

A hypothetical example is if a man has $1,000,000 which doubles every 10 years in the bank, while living expenses (initially $100,000 every 10 years) also doubles every 10 years. The man will have $1,900,000 after the first decade, $3,600,000 after the second, and $6,800,000 after the third (ignoring inflation before each 10-year mark), and will thus feel safe because each 10 years his net gains (interest subtract living expenses) are more than the previous 10 years, even though his purchasing power is decreasing because the interest rate matches inflation rate.

See also

• Behavioural economics
• Fiscal Illusion
• Framing (social science)
• Homo economicus
• Map-territory relation
• The Mandrake Mechanism

References

Further reading

• Fehr, Ernst; Tyran, Jean-Robert (2001), "Does Money Illusion Matter?", American Economic Review 91 (5): 1239–1262, doi:10.1257/aer.91.5.1239, JSTOR 2677924 
• Howitt, P. (1987), "money illusion", The New Palgrave: A Dictionary of Economics 3, London: Macmillan, pp. 518–519, ISBN 0-333-37235-2 
• Weber, Bernd; Rangel, Antonio; Wibral, Matthias; Falk, Armin (2009), "The medial prefrontal cortex exhibits money illusion", PNAS 106 (13): 5025–5028, doi:10.1073/pnas.0901490106, PMC 2664018, PMID 19307555 
• Akerlof, George A.; Shiller, Robert J. (2009), Animal Spirits, Princeton University Press, pp. 41–50 
• Thaler, Richard H.(1997) "Irving Fisher: Modern Behavioral Economist" in The American Economic Review Vol 87, No 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997)
• Huw Dixon (2008), New Keynesian Economics, New Palgrave Dictionary of Economics New Keynesian macroeconomics.