Money illusion

Money illusion

Money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, people mistake nominal variables for real variables. The term was coined by John Maynard Keynes in the early twentieth century, and Irving Fisher wrote an important book on the subject, 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. Shafir, Diamond and Tversky (1997) have provided compelling 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.

It has been contended that money illusion influences economic behaviour in three main ways:

Money illusion can also influence people's perceptions of outcomes. Experiments have shown that people generally perceive a 2% cut in nominal income as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. Further, money illusion means nominal changes in price can influence demand even if real prices have remained constant (Patinkin, 1969).

Some have suggested that money illusion implies that the negative relationship between inflation and unemployment described by the Phillips curve might hold, contrary to recent macroeconomic theories. 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.

Explanations of money illusion generally describe the phenomenon in terms of heuristics. Nominal prices provide a convenient rule of thumb for determining value and real prices are only calculated if they seem highly salient (eg. in periods of hyperinflation or in long term contracts).

References

  • Fisher, I. (1928): The Money Illusion
  • Fehr, E; Tyran, J. R. (2001): Does Money Illusion Matter?. American Economic Review, 91 , 1239-1262.
  • Howitt, P. (1987), "money illusion," The New Palgrave: A Dictionary of Economics, v. 3, 518-19.
  • Shafir, E.; Diamond, P.A. & Tversky, A. (1997) 'On Money Illusion'. Quarterly Journal of Economics, 112(May), 341-74.

See also

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