Money illusion

Self Assessment

Money illusion is a cognitive bias where people tend to think of currency in nominal rather than real terms, ignoring inflation or deflation's impact on purchasing power. This illusion can mislead people's understanding of personal finances, wages, and economic policies by focusing on the face value of money instead of its actual purchasing influence.

How it works

Money illusion arises from the human tendency to evaluate outcomes based on nominal, easily accessible figures rather than adjusting for economic changes such as inflation. This bias exploits people's preference for stable and simple figures, ignoring the nuanced reality of purchasing power or cost of living alterations.

Examples

  • An employee might feel better receiving a nominal pay raise that fails to outpace inflation, falsely interpreting it as an increase in their economic well-being.
  • Homeowners may overvalue the appreciation of property prices without accounting for inflation, misjudging their actual economic gain.

Consequences

  • Miscalculation of financial decisions, leading to poor savings and investment strategies.
  • Economic policies might fail to achieve desired responses because policymakers underestimate how individuals perceive economic variables nominally.
  • Consumers might overspend or under spend based on misleading notions of their income and savings.

Counteracting

To counteract money illusion, individuals and policymakers should focus on real rather than nominal values. This can be achieved through financial education that emphasizes inflation-adjusted thinking, encouraging awareness and understanding of real financial outcomes rather than nominal figures.

Critiques

  • Some argue that money illusion is not as pervasive as suggested, asserting that individuals and markets do eventually adjust to real terms as economic understanding increases.
  • Critics also point out that in stable economies with low inflation, the practical impact of money illusion is often limited.

Fields of Impact

Economics & Finance
Psychology & Social Science
Behavioral Science

Also known as

Nominal bias
Inflation neglect

Relevant Research

  • Money illusion

    Shafir, E., Diamond, P., & Tversky, A. (1997)

    The Quarterly Journal of Economics, 112(2), 341-374

  • Does money illusion matter? American Economic Review, 91(5), 1239-1262

    Fehr, E., & Tyran, J. (2001)

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