economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics anal ...

, money illusion, or price illusion, is a

cognitive bias A cognitive bias is a systematic pattern of deviation from norm (philosophy), norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the ...

where

money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money ar ...

is thought of in nominal, rather than real terms. In other words, the face value (nominal value) of money is mistaken for its

purchasing power Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would ...

(real value) at a previous point in time. Viewing purchasing power as measured by the nominal value is false, as modern

fiat currencies Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...

have no intrinsic value and their real value depends purely on the

price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set ...

. The term was coined by

Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt de ...

in ''Stabilizing the Dollar''. It was popularized by

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

in the early twentieth century, and

wrote an important book on the subject, ''The Money Illusion'', in 1928. The existence of money illusion is disputed by

monetary Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are ...

economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. Eldar Shafir,

Peter A. Diamond Peter Arthur Diamond (born , 1940) 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 Memoria ...

, and

Amos Tversky Amos Nathan Tversky ( he, עמוס טברסקי; March 16, 1937 – June 2, 1996) was an Israeli cognitive and mathematical psychologist and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his ...

(1997) have provided

empirical evidence Empirical evidence for a proposition is evidence, i.e. what supports or counters this proposition, that is constituted by or accessible to sense experience or experimental procedure. Empirical evidence is of central importance to the sciences ...

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 stickiness. Money illusion has been proposed as one reason why

nominal price In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not c ...

s are slow to change even where

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...

has caused

real price In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not ...

s to fall or costs to rise. *

Contracts A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tr ...

and

laws Law is a set of rules that are created and are enforceable by social or governmental institutions to regulate behavior,Robertson, ''Crimes against humanity'', 90. with its precise definition a matter of longstanding debate. It has been vari ...

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 an approximate 2% cut in nominal income with no change in monetary value as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. This result is consistent with the 'Myopic Loss Aversion theory'. Furthermore, the money illusion means nominal changes in price can influence demand even if real prices have remained constant.

Explanations and implications

Explanations of money illusion generally describe the phenomenon in terms of

heuristics A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...

. 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 In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...

or in long term contracts). Some have suggested that money illusion implies that the negative relationship between inflation and unemployment described by the

Phillips curve The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship ...

might hold, contrary to more recent

macroeconomic Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, an ...

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. Money illusion is believed to be instrumental in the Friedmanian version of the

. Actually, money illusion is not enough to explain the mechanism underlying this Phillips curve. It requires two additional assumptions. First, prices respond differently to modified demand conditions: an increased aggregate demand exerts its influence on commodity prices sooner than it does on labour market prices. Therefore, the drop in unemployment is, after all, the result of decreasing real wages and an accurate judgement 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 refers to a special 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.

Explanations and implications

See also

References

Further reading