What Is Money Illusion?
Money illusion is an economic theory that suggests that people tend to view their wealth and income in nominaldollar terms rather than in real terms. Put simply, money allusion means that people don't account forinflationin an economy and wrongly believe that a dollar is worth the same as it was the prior year.
Key Takeaways
- Money illusion posits that people have a tendency to view their wealth and income in nominaldollar terms, rather than recognize their real value, adjusted for inflation.
- Economists cite factors such as a lack of financial education and theprice stickinessseen in many goods and services as triggers of money illusion.
- Employers are sometimes said to take advantage of this, modestly lifting wages in nominal terms without actually paying more in real terms.
Understanding Money Illusion
As noted above, money illusion is an economic theory that suggests that people consider their wealth and income only in nominal rather than real terms. This means that they think of their money in current or face values rather than their relative values. The latter can fluctuate, as it is the value adjusted for inflation.
Money illusion is often cited as a reason why small levels of inflation—1% to2%per year—are desirable for an economy. Low inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.
People's perceptions of financial outcomes are colored by money illusion. Experiments have shown, for example, that people generally perceive a2% paycut in nominal income with no change in monetary value as unfair. However, they also perceivea 2%rise in nominal income, when inflation is running at 4%, as fair.
Money illusion is sometimes also referred to as price illusion.
History of Money Illusion
Although British economist John Maynard Keynes is credited with helping to popularize it, the term money illusion was first coined by American economist Irving Fisher in his book “Stabilizing the Dollar.” Fisher later wrote an entire book dedicated to the topic in 1928, titled “The Money Illusion.”
Money illusion is a psychological matter that continues to be debated among economists. Some disagree with the theory, arguing that people automatically think of their money in real terms, adjusting for inflation because they see price changes every time they enter a store.
Others claim that it is rife, citing factors such as a lack of financial education, and theprice stickinessseen in many goods and services as reasons why people might fall into the trap of ignoring the rising cost of living.
Money Illusion vs. the Phillips Curve
Money illusion is understood to be a key aspect in theFriedmanian version of thePhillips curve—a popular tool for analyzing macroeconomic policy. The Philips curve claims that economic growthis accompanied by inflation, which in turn should lead to more jobs and less unemployment.
Money illusion helps to sustain that theory. It argues that employees seldom demand an increase in wages to compensate for inflation, making it easier for firms to hire staff on the cheap. Still, money illusion doesn't adequatelyaccount forthe mechanism at work in the Phillips curve.To do sorequires two additional assumptions.
First, prices respond differently to modified demand conditions: An increase inaggregate demand affectscommodity prices sooner than it affects labormarket prices. Thus, adrop in unemployment is, after all, an outcome ofdecreasing real wages, and an accurate judgment of the situation by employees is the only reason for the return to an initial (natural) rate of unemployment (i.e. the end of the money illusion, when they finally recognize the actual dynamics of prices and wages).
The other (arbitrary) assumption relates specifically tospecial informational asymmetry: Whatever employees are unaware of, in connection with the changes in (real and nominal) wages and prices, can be clearly observed by employers. The new classical version of the Phillips curve was aimed at removing the puzzling additional presumptions, but its mechanism still requires money illusion.
What Is an Example of Money Illusion?
Money illusion occurs when individuals treat the value of their money (their wealth and income) in terms of its nominal value rather than in real terms. This means they don't take inflation into account when considering the value of their money.
One example of money illusion is when people get a raise. Consider a company that gives offers an employee a 3% increase. This means the employee, who earns $25,000 per year, gets an extra $750. It might seem like the employee has extra money in their pocket on a nominal level, But if you consider that prices are going up by 5%, the employee doesn't really get to keep much of that increase when all is said and done.
How Do You Avoid Money Illusion?
One of the best ways to avoid falling into the trap of money illusion is to understand how inflation affects the value of money and its purchasing power. It's important to realize that the face value of your money does not go as far as it does when prices rise. But when they fall, you may be able to stretch your money even more. You'll also be able to understand how much money you need to earn to keep up with your standard of living and meet your goals based on current economic conditions.
What's the Difference Between Nominal and Real Value in Economics?
The term nominal value in economics refers to the value of something at the current price. This can include the price of goods and services, or the value of money. Real value, on the other hand, refers to the value of something when inflation is considered. This means that the real value is relative over time.
The Bottom Line
It can be easy to fall into the trap of money illusion—thinking that your money is worth more than it actually is. To avoid this, it's important to understand that although the face value of your money doesn't change, your purchasing power—that is, how far your dollar goes—does change. That's because inflation can impact how much you can buy. When prices increase, your money can't buy as much. Conversely, your money will go farther when prices drop.
