What Is Money Illusion?
Money illusion is an economic theory suggesting that people tend to view their wealth and income in nominal dollar terms, rather than in real terms. This implies that individuals often overlook the level of inflation in an economy, mistakenly assuming that a dollar today holds the same value as it did the previous year.
Money illusion is sometimes also referred to as price illusion.
Key Takeaways
- Money illusion posits that people tend to see their wealth and income in nominal dollar terms rather than their real value, adjusted for inflation.
- Factors like a lack of financial education and the price stickiness in many goods and services are often cited as triggers of money illusion.
- Employers may exploit this phenomenon by modestly increasing wages in nominal terms without actually paying more in real terms.
Understanding Money Illusion
Money illusion revolves around psychological perceptions and is a debated topic among economists. Some argue that people instinctively think about money in real terms, automatically adjusting for inflation because they notice price changes every time they shop.
Others claim that money illusion is widespread, attributing it to a lack of financial education and the price stickiness seen in numerous goods and services. These factors lead people to ignore the rising cost of living.
Moreover, money illusion is often used to justify low levels of inflation (1%–2% per year), considered beneficial for an economy. Low inflation permits employers to slightly increase nominal wages without actually increasing real wages, making employees feel wealthier despite inflation.
Experiments demonstrate the influence of money illusion on financial perceptions. For instance, most people view a 2% cut in nominal income with no inflation as unfair. Conversely, they find a 2% rise in nominal income, when inflation is at 4%, to be fair.
A Glimpse into the History of Money Illusion
The term “money illusion” was first introduced by American economist Irving Fisher in his book “Stabilizing the Dollar.” Fisher further detailed the concept in his 1928 book titled “The Money Illusion.” British economist John Maynard Keynes also played a significant role in popularizing the term.
Money Illusion vs. the Phillips Curve
Money illusion is a crucial component in the Friedmanian version of the Phillips curve, a widely used tool for analyzing macroeconomic policy. The Phillips curve suggests that economic growth leads to inflation, which should consequently reduce unemployment.
Money illusion supports this theory by proposing that employees are less likely to demand wage increases to match inflation, making it easier for employers to hire at lower costs. However, this theory requires more assumptions.
First, different price response timelines to demand modifications: an increase in aggregate demand affects commodity prices faster than labor market prices. Through this lens, a decrease in unemployment results from reducing real wages. An accurate understanding by employees ends money illusion when they recognize the actual dynamics of prices and wages.
The second assumption involves a unique informational asymmetry: employees may be unaware of changes in real and nominal wages and prices, while employers clearly understand these changes. The new classical version of the Phillips curve attempts to eliminate these puzzling assumptions but still relies on the concept of money illusion.
Related Terms: inflation, real value, nominal terms, price stickiness, financial education
