Money illusion

In economics, money illusion, or price illusion, is a cognitive bias where money 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 (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 term was coined by Irving Fisher in Stabilizing the Dollar. It was popularized by John Maynard Keynes in the early twentieth century, and Irving Fisher wrote an important book on the subject, The Money Illusion, in 1928.^[1]

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.^[2] Eldar Shafir, Peter A. Diamond, and Amos Tversky (1997) have provided empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations.^[3]

Shafir et al.^[3] also state that money illusion influences economic behaviour in three main ways:

• Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices to fall or costs to rise.
• Contracts and laws 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'.^[4] Furthermore, the money illusion means nominal changes in price can influence demand even if real prices have remained constant.^[5]