Money illusion
Encyclopedia
In economics
, money 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 and used for payment of taxes.
The term was coined by John Maynard Keynes
in the early twentieth century, and Irving Fisher
wrote an important book on the subject, The Money Illusion, in 1928. 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. Shafir, Diamond
and Tversky
(1997) have provided compelling 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.
Shafir et al. also state that money illusion influences economic behaviour in three main ways:
Money illusion can also influence people's perceptions of outcomes. Experiments have shown that people generally perceive a 2% cut in nominal income 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. Further, money illusion means nominal changes in price can influence demand even if real prices have remained constant.
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". 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).
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, money 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
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
(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 and used for payment of taxes.
The term was coined by John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
in the early twentieth century, and Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
wrote an important book on the subject, The Money Illusion, in 1928. 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. Shafir, Diamond
Peter A. Diamond
Peter Arthur Diamond is an American economist known for his analysis of U.S. Social Security policy and his work as an advisor to the Advisory Council on Social Security in the late 1980s and 1990s. He was awarded the Nobel Memorial Prize in Economic Sciences in 2010, along with Dale T. Mortensen...
and Tversky
Amos Tversky
Amos Nathan Tversky, was a cognitive and mathematical psychologist, a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his early work concerned the foundations of measurement...
(1997) have provided compelling 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.
Shafir et al. also state that money illusion influences economic behaviour in three main ways:
- Price stickinessSticky (economics)Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
. 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 a 2% cut in nominal income 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. Further, money illusion means nominal changes in price can influence demand even if real prices have remained constant.
Some have suggested that money illusion implies that the negative relationship between inflation and unemployment described by the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
might hold, contrary to recent macroeconomic theories such as the "expectations-augmented Phillips curve". 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
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...
or in long term contracts).
See also
- Framing (social science)
- Behavioural economics
- Homo economicusHomo economicusHomo economicus, or Economic human, is the concept in some economic theories of humans as rational and narrowly self-interested actors who have the ability to make judgments toward their subjectively defined ends...
- The Mandrake Mechanism
- Map-territory relation
- Fiscal IllusionFiscal IllusionFiscal illusion is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani.Fiscal illusion suggests that when government revenues are unobserved or not fully observed by taxpayers then the cost of government is perceived to be less expensive than...
Further reading
- Erber, Georg (2010), The Problem of Money Illusion in Economics. In: Journal of Applied Economic Sciences. vol. 5, issue 3(13), 2010, , S. 196–216 (PDF-File; JAES Online).