Money illusion

What Is Money Illusion?

Money illusion is a cognitive bias where individuals tend to think about monetary values in nominal terms rather than in real, inflation-adjusted terms. It is a concept central to the field of behavioral economics, highlighting how human psychology can lead to seemingly irrational economic decision-making. Essentially, someone experiencing money illusion might perceive a numerical increase in their income or wealth as an improvement in their financial well-being, even if that increase is fully or more than offset by inflation. This bias means people fail to fully grasp that the purchasing power of money can change over time.

History and Origin

The concept of money illusion was first coined by American economist Irving Fisher in the early 20th century, notably in his 1928 book, The Money Illusion. Fisher defined it as the "failure to perceive that the dollar, or any other unit of money, expands or shrinks in value."¹⁵ He explored how a combination of rising prices and this cognitive bias could destabilize an economy. An early review of The Money Illusion highlighted Fisher's exploration of this human tendency to misunderstand the true value of money.

The idea gained further prominence through the work of John Maynard Keynes, who also popularized the concept in macroeconomics.¹⁴ While classical economic theory often assumed individuals acted rationally, behavioral economists have provided significant empirical evidence for the existence of money illusion, demonstrating its influence on various real-world situations and choices. More recently, Nobel laureates George A. Akerlof and Robert J. Shiller identified money illusion as one of the "animal spirits" that influence economic fluctuations, alongside factors like confidence and fairness, as discussed in their work on "animal spirits".¹¹, ¹², ¹³

Key Takeaways

• Money illusion is a cognitive bias where people focus on the nominal value of money rather than its real value, which accounts for inflation.
• It can lead individuals to misjudge changes in their income, wealth, or prices, affecting their financial well-being.
• First identified by Irving Fisher and popularized by John Maynard Keynes, money illusion is a key concept in behavioral economics.
• This bias can influence decisions related to wages, savings, and investments.

Interpreting Money Illusion

Interpreting money illusion involves recognizing the discrepancy between nominal and real values. When individuals are affected by money illusion, they interpret financial figures at their face value without considering changes in the overall price level due to inflation or deflation. For instance, a person might feel wealthier after receiving a 5% raise, even if inflation is running at 7%. In this scenario, their nominal income increased, but their real purchasing power actually decreased by 2%.¹⁰

Understanding money illusion is crucial because it can distort perceptions of financial health. It highlights that reported figures, such as gross domestic product (GDP) growth or corporate earnings, should ideally be evaluated after adjusting for inflation to reflect their true economic impact. This distinction between nominal and real terms is fundamental in sound financial analysis.

Hypothetical Example

Consider an individual, Sarah, who received a 3% salary increase at her job. Her annual salary went from $60,000 to $61,800. At first glance, Sarah feels positive about this raise, believing her financial situation has improved. This is an instance of money illusion.

However, during the same year, the rate of inflation was 4%. While Sarah's nominal salary increased, the prices of goods and services she typically buys also increased. To calculate her real change in purchasing power, we would adjust her nominal wage increase by the inflation rate.

Real Wage Change = Nominal Wage Increase - Inflation Rate
Real Wage Change = 3% - 4% = -1%

Despite receiving a pay raise in nominal terms, Sarah's real purchasing power actually decreased by 1%. Because of money illusion, she might not immediately recognize this decline in her ability to purchase goods and services. If she had been fully rational, she would have recognized that her actual wealth declined, even with the higher nominal paycheck.

Practical Applications

Money illusion has several practical applications in various aspects of finance and economics:

• Wage Negotiations: Employees affected by money illusion might accept smaller real wage increases or resist nominal wage cuts more fiercely than real wage cuts, even if the real outcome is the same. This can lead to wage stickiness, where nominal wages are slow to adjust downwards, impacting unemployment during economic downturns.⁹
• Monetary Policy: Central banks and policymakers may consider the existence of money illusion when setting monetary policy. For example, a modest level of inflation (e.g., 1-2%) is sometimes considered desirable partly because it allows employers to increase nominal wages without necessarily increasing real wages, potentially easing labor market adjustments. Research from central banks, such as the Riksbanken, often explores how money illusion can cause households to overlook inflation in their economic decisions.⁸
• Investment Decisions: Investors can fall prey to money illusion by focusing on nominal returns rather than inflation-adjusted returns. A bond yielding 5% might seem attractive, but if inflation is 4%, the real return is only 1%. This can lead to suboptimal investments or a misallocation of capital.⁷
• Government Finance: Governments might inadvertently leverage money illusion by boasting about nominal increases in spending (e.g., on healthcare or infrastructure) without clearly communicating the real, inflation-adjusted impact.⁶

Limitations and Criticisms

While widely recognized in behavioral economics, the extent and impact of money illusion are still debated among economists. Some classical and neoclassical economists argue that rational economic agents should, over time, adjust to changes in price levels and focus on real values. They contend that any money illusion is likely short-lived or only affects a subset of the population, especially in economies with stable price levels.⁵

Critics also point out that in an era of readily available economic data, individuals have more tools to understand interest rates, inflation rates, and real returns. However, proponents of money illusion argue that cognitive shortcuts, psychological biases, and a lack of financial education can still make individuals susceptible.⁴ For instance, empirical studies have shown that people may perceive a nominal pay cut as unfair, even if their real purchasing power would increase due to deflation. Conversely, they may view a nominal pay raise as fair, even if inflation erodes their real income.³ These findings suggest that while not universally accepted, the phenomenon of money illusion remains a significant consideration in understanding real-world economic behavior. Research on money illusion by Eldar Shafir, Peter Diamond, and Amos Tversky, among others, has provided strong support for its existence through various empirical studies.¹, ²

Money Illusion vs. Nominal vs. Real Value

Money illusion is directly related to, but distinct from, the concepts of nominal and real value.

The confusion between nominal value and real value is precisely what money illusion describes. While nominal value is the amount of money at face value (e.g., a $50,000 salary), real value adjusts that nominal amount for changes in the price level (i.e., inflation or deflation) to reflect its actual purchasing power. Money illusion occurs when an individual fails to make this crucial adjustment, leading to distorted perceptions of economic well-being or cost.

FAQs

Why is money illusion important in economics?

Money illusion is important because it demonstrates that people do not always act perfectly rationally when making financial decisions. It suggests that psychological factors can influence economic behavior, leading to different outcomes than what traditional economic models, which assume full rationality, might predict. This understanding is key for fields like behavioral economics and for policymakers trying to gauge public reactions to economic changes.

Can individuals overcome money illusion?

While money illusion is a pervasive cognitive bias, individuals can mitigate its effects by consciously focusing on real, inflation-adjusted values rather than nominal ones. Financial education plays a role in helping people understand the impact of inflation on their purchasing power and encouraging them to calculate real returns on investments and real changes in income.

How does money illusion affect retirement planning?

Money illusion can negatively impact retirement planning because individuals might underestimate the amount of savings they need to maintain their lifestyle in the future. If they only consider the nominal value of their current savings, they may not adequately account for the erosion of purchasing power due to long-term inflation, potentially leading to a shortfall in retirement funds.