In
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 analy ...
, money illusion, or price illusion, is a
cognitive bias
A cognitive bias is a systematic pattern of deviation from 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 objective input, ...
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 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 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
Irving Fisher wrote an important book on the subject, ''The Money Illusion'', in 1928.
The existence of money illusion is disputed by
monetary 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) 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 Behavioral Science and Public P ...
,
Peter A. Diamond, 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
Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For exampl ...
. 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 ...
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 reductio ...
has caused
real prices 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 ...
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 vario ...
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 (or, in effect, "named") 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. ...
.
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 (economist), William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did no ...
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
An economy is an area of the production, distributio ...
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
Phillips curve
The Phillips curve is an economic model, named after William Phillips (economist), William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did no ...
. 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.
See also
*
Behavioural economics
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory.
...
*
Fiscal Illusion
*
Framing (social science)
*
Homo economicus
*
Map-territory relation
References
Further reading
*
*
*
*
* Thaler, Richard H.(1997
"Irving Fisher: Modern Behavioral Economist"in ''The American Economic Review'' Vol 87, No 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997)
*
Huw Dixon
Huw David Dixon (/hju: devəd dɪksən/), born 1958, is a British economist. He has been a professor at Cardiff Business School since 2006, having previously been Head of Economics at the University of York (2003–2006) after being a professor ...
(2008)
New Keynesian Economics New Palgrave Dictionary of Economic
New Keynesian macroeconomics
{{DEFAULTSORT:Money Illusion
Heuristics
Inflation
Behavioral finance
Cognitive biases