What Is Money Illusion?

Money illusion is an economic theory that suggests that people tend to view their wealth and income in nominal dollar terms rather than in 澳洲幸运5开奖号码历史查询:real terms. Put simply, money allusion means that people don't account for inflation in an economy and wrongly believe that a dollar is worth the same as it was the prior year.

Understanding Money Illusion

As noted above, money illusion is an 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:inflation—1% to 2% per year—are desirable for an economy. Low inflation allows employers, for example, to modestly raise wages in nominal tܫerms 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 a 2% pay cut in nominal income with no change in monetary value as unfair. However, they also perceiv💟e a 2% rise in nominal income, when inflation is running at 4%, as fair﷽.

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 澳洲幸运5开奖号码历史查询:economists. Some disagree with the theory, arguing that people automatically think of their money in real terms, adjusting for inflation because they se🗹e price chang𒅌es every time they enter a store.

Others claim that it is rife, citing factors such as a lack of financial education, and the 澳洲幸运5开奖号码历史查询:price stickiness seen in many goods and services as reasons why people might fall into the trap of ignoring the rising cost o꧋f living.

Money Illusion vs. the Phillips Curve

Money illusion is understood to be a key aspect in the 澳洲幸运5开奖号码历史查询:Friedmanian version of the 澳洲幸运5开奖号码历史查询:Phillips curve—a popular tool for analyzing 澳洲幸运5开奖号码历史查询:macroeconomic policy. The Philips curve claims that 澳洲幸运5开奖号码历史查询:economic growth is accompanied by inflation, which in turn should lead to more jobs and less 澳洲幸运5开奖号码历史查询: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 adequately account for the mechanism at work in the Phillips curve. To do so requires two additional assumptions.

First, prices respond differently to modified demand conditions: An increase in 澳洲幸运5开奖号码历史查询:aggregate demand affects 澳洲幸运5开奖号码历史查询:commodity prices sooner than it affects 澳洲幸运5开奖号码历史查询:labor market prices. Thus, a drop in unemployment is, after all, an outcome of decreasing real wages, and an accurate judgme🔯nt 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 to special 澳洲幸运5开奖号码历史查询: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 clꦬassical version of the Phillips curve was aimed at removing the puzzling additional presumptions, but its mechanism still requires money illusion.

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.