What is the Money Illusion?

The money illusion is a phenomenon characterized by people failing to take the changing value of money into account, thinking purely in nominal terms when they consider their financial situations. This excludes inflation and may mislead people into thinking that they are better or worse off than they really are. The money illusion can be seen in action in a number of different ways in societies all over the world.

Economists and psychologists have studied the money illusion since the 1920s, when it first began to be extensively documented. One consequence of this phenomenon is that people do not consider inflation when evaluating the costs of products and services or their own salaries. If the price of a product appears to rise, for example, people may complain that it is getting “more expensive” when it is actually keeping pace with inflation.

Conversely, someone who receives raises that do not keep pace with inflation may have difficulty recognizing that he or she is actually worse off. When the pace of inflation exceeds annual raises, employees end up earning less in real terms than they did in previous years. In nominal terms, however, they are making more money. Since the money illusion leads people to focus on the nominal rather than on the real, they do not realize that their wages are actually moving backward.

Another area in which the money illusion can be observed is in foreign exchange. People sometimes have difficulty spending in different currencies not because they have trouble doing math, but because they have difficulty making the leap between different economies. Goods and services may seem more expensive as a result of the currency shift, leading people to be more cautious about their spending.

Some people have argued that the money illusion isn't real and that people are perfectly capable of distinguishing between money in nominal and real terms. However, numerous studies have suggested that this is not actually the case. When studies ask subjects if they would prefer a two percent raise each year and no inflation or a five percent raise and four percent inflation every year, for example, they often choose the five percent raise. The ability to distinguish between real and nominal values for money is very important for people considering issues such as raises and changing costs of goods and services so that they understand the real meaning which underlies the quoted nominal values.