Money Illusion

Published Oct 25, 2023

Definition of Money Illusion

Money illusion refers to the tendency of individuals to perceive changes in monetary value based on nominal values rather than real values. In other words, people often focus on the face value of money without considering changes in purchasing power due to inflation or deflation.

Example

To illustrate money illusion, let’s imagine a scenario where Sarah, an employee, receives a 5% raise in her annual salary. At first glance, Sarah may be pleased with the increase in her income, assuming that she is better off financially. However, if there is an inflation rate of 6%, Sarah’s purchasing power has actually decreased, despite the nominal increase in her salary.

Due to money illusion, Sarah might not realize that her salary increase is insufficient to keep up with the rising cost of goods and services. As a result, she may continue to make purchases as if her income has increased, leading to a decrease in her overall financial well-being.

Why Money Illusion Matters

Understanding money illusion is important because it highlights the importance of considering real values, such as purchasing power, rather than simply focusing on nominal values. By considering the effects of inflation or deflation, individuals can make more informed financial decisions and accurately assess changes in their wealth.

Moreover, money illusion can have implications for economic policy. Individuals who exhibit money illusion may react differently to changes in nominal prices compared to changes in real prices. This can impact consumer behavior, investment decisions, and overall market dynamics. Policymakers need to take this phenomenon into account when formulating monetary policies and communicating the impact of such policies to the general public.