economics Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and interac ...

, 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 are: m ...

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 refers to the amount of products and services available for purchase with a certain currency unit. For example, if you took one unit of cash to a store in the 1950s, you could buy more products than you could now, showing that th ...

(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 is a type of government-issued currency that is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity. Fiat currency is typically designated by the issuing government to be legal tender, ...

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 and philosopher whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originall ...

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: med ...

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

Eldar Shafir Eldar Shafir (Hebrew: אלדר שפיר ''eldár shafír'', born 1959) is an American behavioral scientist, and the co-author of ''Scarcity: Why Having Too Little Means So Much'' (with Sendhil Mullainathan). He is the Class of 1987 Professor in B ...

, Peter A. Diamond, and

Amos Tversky Amos Nathan Tversky (; 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 early work concerned th ...

(1997) have provided

empirical evidence Empirical evidence is evidence obtained through sense experience or experimental procedure. It is of central importance to the sciences and plays a role in various other fields, like epistemology and law. There is no general agreement on how the ...

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 refers to value measured in terms of absolute money amounts, whereas real value is considered and measured against the actual goods or services for which it can be exchanged at a given time. Real value takes into acco ...

s are slow to change even where

inflation In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

has caused real prices to fall or costs to rise. *

Contracts A contract is an agreement that specifies certain legally enforceable rights and obligations pertaining to two or more parties. A contract typically involves consent to transfer of goods, services, money, or promise to transfer any of thos ...

and

laws Law is a set of rules that are created and are law enforcement, enforceable by social or governmental institutions to regulate behavior, with its precise definition a matter of longstanding debate. It has been variously described as a Socia ...

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 In economics, nominal value refers to value measured in terms of absolute money amounts, whereas real value is considered and measured against the actual goods or services for which it can be exchanged at a given time. Real value takes into acc ...

. 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 (''problem solving'', '' mental shortcut'', ''rule of thumb'') is any approach to problem solving that employs a pragmatic method that is not fully optimized, perfected, or rationalized, but is nevertheless ...

. 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 versus nominal value (economics), real value of the local currency, as the prices of all goods increase. This causes people to minimiz ...

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 Bill Phillips, that correlates reduced unemployment with increasing wages in an economy. While Phillips did not directly link employment and inflation, this was a trivial deduction from his ...

might hold, contrary to more recent

macroeconomic Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/ GDP ...

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