Money Illusion

An economic theory that states that individuals usually tend to view their income and wealth in nominal terms, as opposed to real terms

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What is Money Illusion?

Money illusion, also known as price illusion, is an economic theory that states that individuals usually tend to view their income and wealth in nominal terms, as opposed to real terms.

Money Illusion

Another way to think about the money illusion concept is to assume that individuals do not take into account the effects of inflation on their money, so they wrongly believe that their accumulated wealth is worth the same as the prior year.

History of the Money Illusion Concept

“The Money Illusion” is a book that was authored by economist Irving Fisher in 1928. Fisher’s book detailed a German shopkeeper during a time when Germany’s currency (The German mark at the time, not the euro) was undergoing massive devaluation due to hyperinflation. A hyperinflation is an event where there is very high and accelerating inflation – Germany experienced one after World War 1.

The shopkeeper was under the belief that because she was selling shirts above the cost she acquired them for, she was making a profit. However, according to Fisher, the shopkeeper received less money, or lost money, from selling her shirts. It is because the shopkeeper had lost purchasing power, or the number of goods and services she could purchase with the same amount of money, due to inflationary pressures.

Fisher concluded that people think about their wealth in nominal terms, not in real terms, which provided a false sense of security for an individual’s wealth.

Understanding Money Illusion

The money illusion is psychological in nature – individuals falsely believe in the accumulation of their wealth, but they do not account for inflation. Due to such fact, and assuming that inflation is persistently positive, an individual’s wealth will often be overstated.

Economists believe that money illusions exist for a couple of reasons:

  • Lack of financial education – Often, people do not account for the effects of inflation on their purchasing power or they simply do not know about inflation.
  • Price stickiness in goods and services – Sometimes, prices for goods and services will not change in price even though the overall economy is signaling that they should.

Economists also cite money illusion as the main reason why inflation is good in the economy. Specifically:

  • Inflation allows wage increases – When inflation is low, employers will often provide modest raises in nominal wages.

Money Illusion and the Phillips Curve

Money illusion is a key concept that Milton Friedman incorporated into his version of the Philips curve, which is an economic tool that depicts the inverse relationship between unemployment and inflation.

Friedman believed that money illusion assisted the validity of the Philips curve theory, mainly because:

  • Employees do not demand increasing wages – Since individuals see their wealth in nominal terms, they hardly ask for inflation-linked increases in wage. It, in turn, allowed the company to hire more employees at a lower cost.

In other words, as inflation increased and employees did not ask for wage increases, the company simply hired more individuals, thus lowering unemployment.

  • Prices respond differently to modified demand conditions – Friedman believed that an increase in the aggregate demand affected commodity prices sooner than it affected labor market prices.

As such, a decrease in the unemployment rate is an outcome that is linked to decreasing real wages. As employees realize that their real wages are decreasing, the natural rate of unemployment will return to a natural level because employers cannot afford the real wages.

  • Informational asymmetry exists – Employers will capitalize on employees who are unaware of changes in their real or nominal wages and prices.

Money Illusion Examples

To provide a concrete example of money illusion, assume the following:

  • Annual inflation: 2%
  • Real accumulated wealth (excl. the current year): $600,000
  • Net annual income after expenses: $100,000

An individual who falls for the money illusion trap will believe the following:

  • That the $600,000 will persist in its value (will be equal to $600,000 by the end of the year).
  • Assume the $100,000 does not need to be adjusted for inflation, thus the individual would’ve accumulated another $100,000 by the end of the year.
  • Therefore, the individual will believe their wealth is $700,000.

However, the individual’s actual wealth is:

  • The $600,000 will deteriorate by 2% or the rate of inflation, which means that the $600,000 will be equal to $588,000 by the end of the year.
  • Assume the $100,000 does not need to be adjusted for inflation, thus the individual would’ve accumulated another $100,000 by the end of the year.
  • Therefore, the individual’s wealth will be $688,000 ($12,000 below what they would believe to own if they fell for the money illusion trap).

Another interesting example of money illusion can be derived from the following situations:

  • An individual will usually see a 2% cut to nominal wages as unfair (or they lose 2% of their purchasing power).
  • An individual will usually see a 2% nominal increase in wages, while inflation is 4%, as fair (or they lose 2% of their purchasing power).

Both situations result in the same financial outcome, but individuals do not usually see it that way. Money illusion remains an interesting topic in behavioral finance.

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