Money Illusion Overview History and Examples

Money Illusion Overview History and Examples

Money Illusion: Overview, History, and Examples

What Is Money Illusion?

Money illusion is the economic theory that suggests people view their wealth and income in nominal dollar terms, rather than in real terms. This means they do not consider the level of inflation in an economy and mistakenly believe that a dollar is worth the same as it was in the previous year. Money illusion is also known as price illusion.

Key Takeaways

– Money illusion suggests that people view their wealth and income in nominal dollar terms, instead of recognizing their real value adjusted for inflation.

– Factors such as a lack of financial education and price stickiness in goods and services can trigger money illusion.

– Employers can take advantage of money illusion by slightly increasing wages in nominal terms without actually paying more in real terms.

Understanding Money Illusion

The concept of money illusion is debated among economists. Some argue that people automatically consider their money in real terms, adjusting for inflation since they observe price changes when shopping. Others claim that money illusion is prevalent, citing factors like a lack of financial education and price stickiness in goods and services as reasons why people might ignore rising living costs.

Money illusion is often seen as a reason why low levels of inflation, around 1% to 2% per year, are beneficial for an economy. It allows employers to raise wages slightly in nominal terms without paying more in real terms. Consequently, individuals who receive pay raises believe their wealth is increasing, irrespective of the actual inflation rate.

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People’s perception of financial outcomes is influenced by money illusion. Experiments have shown that individuals view a 2% pay cut in nominal income, with no change in monetary value, as unfair. However, they perceive a 2% increase in nominal income as fair when inflation is at 4%.

History of Money Illusion

American economist Irving Fisher first coined the term "money illusion" in his book "Stabilizing the Dollar." Fisher later dedicated an entire book to the topic called "The Money Illusion" in 1928. British economist John Maynard Keynes is credited with popularizing the term.

Money Illusion vs. the Phillips Curve

Money illusion plays a significant role in the Friedmanian interpretation of the Phillips curve, a macroeconomic policy analysis tool. The Phillips curve suggests that economic growth leads to inflation, resulting in more jobs and lower unemployment.

Money illusion helps support this theory as it proposes that employees rarely demand wage increases to compensate for inflation, making it easier for companies to hire staff at lower wages. However, money illusion does not fully explain the mechanism in the Phillips curve. Two additional assumptions are required.

Firstly, prices react differently to changes in demand: commodity prices are affected earlier than labor market prices. As a result, a decrease in unemployment is primarily due to declining real wages, and employees’ accurate judgment of the situation is the reason for the return to the initial (natural) rate of unemployment when they finally recognize the actual dynamics of prices and wages.

The other assumption concerns special informational asymmetry: employers have clear visibility into what employees are unaware of regarding changes in real and nominal wages and prices. The new classical version of the Phillips curve aimed to eliminate these additional assumptions, but money illusion remains essential in its mechanism.

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