Money illusion is the tendency of people to think about money in nominal terms, the number of currency units, rather than in real terms, what that money can actually buy. A worker who feels better off after a 2% pay rise when prices have risen 4% is showing money illusion: the payslip is bigger, but its purchasing power has fallen. The term was popularised by the American economist Irving Fisher in his 1928 book The Money Illusion, and the idea also appears in the work of John Maynard Keynes.
Money illusion sits at the meeting point of macroeconomics and behavioral economics. Classical theory assumes that rational people care only about real values, so a doubling of all prices and incomes should change nothing. Evidence that people do in fact anchor on nominal amounts helps explain sticky prices and wages and why inflation has real effects.
Money illusion in plain terms
Think of a ruler that quietly shrinks a little each year. If you measure your height with it, you appear to grow, even though you have not changed at all. Inflation does the same to money: the "ruler" of the currency shrinks, so incomes, house prices and savings balances look larger than they really are.
Money illusion is forgetting that the ruler is shrinking. People feel richer when their salary goes up, feel cheated when a nominal pay cut is proposed even if prices are falling, and are pleased to sell a house for more than they paid without noticing that, after years of rising prices, the gain in buying power may be small or even negative.
Evidence for money illusion
The best-known study is by Eldar Shafir, Peter Diamond and Amos Tversky, published in the Quarterly Journal of Economics in 1997. They asked survey respondents about hypothetical people. In one scenario, a worker received a 2% raise with no inflation; in another, a 5% raise with 4% inflation. Most respondents correctly said the first worker was better off in real terms, yet many said the second worker would feel happier and be less likely to quit. The authors concluded that people reason in both nominal and real terms at once, with nominal values often dominating feelings and quick judgements.
Other evidence includes:
- Resistance to nominal pay cuts. Studies of wage data in the United States and other countries show a spike of zero pay changes and very few nominal cuts, even during recessions when real wages could fall through inflation without complaint. This pattern is a key reason economists see a modest positive inflation rate as useful "grease" for the labour market.
- Housing markets. Research by Markus Brunnermeier and Christian Julliard (2008) argued that investors compare mortgage payments and rents using nominal interest rates, which can misprice property when inflation changes.
- Stock valuation. The hypothesis set out by Franco Modigliani and Richard Cohn in 1979 holds that investors discount real company earnings at nominal rates, undervaluing shares when inflation is high.
- Brain imaging. A 2009 neuroeconomics study found that brain areas associated with reward responded more to larger nominal amounts even when real buying power was identical.
Consequences for wages, saving and policy
Money illusion has several practical consequences:
- The Phillips curve. If workers accept real pay cuts disguised by inflation, unexpected inflation can reduce unemployment in the short run, the trade-off shown by the Phillips curve. Milton Friedman and Edmund Phelps argued in the late 1960s that this effect disappears once people learn to expect inflation, a view reinforced by rational expectations theory.
- Savings and interest. Savers often compare deposit rates with zero instead of with inflation. A 4% nominal interest rate on a savings account sounds attractive but delivers a loss in real terms if inflation is 6%.
- Taxes. Taxes based on nominal values, such as capital gains tax on unindexed gains or frozen income-tax thresholds, can raise real tax burdens without anyone voting for it, the effect called fiscal drag.
- Contracts. One response to money illusion and to inflation's arbitrary effects is indexation of wages, pensions and bonds.
Debate and criticism
Many economists in the neoclassical and new classical traditions long treated money illusion as an irrational error that markets would eliminate; the assumption that only real values matter is called the neutrality of money and underpins the long-run version of the quantity theory of money. George Akerlof, in his 2001 Nobel lecture and related work with William Dickens and George Perry, argued instead that near-rational behaviour of this kind is common and that very low inflation can therefore raise unemployment. Others reply that people with large sums at stake, such as bond investors and pension funds, show little money illusion, and that apparent illusion may reflect fairness norms or bounded rationality rather than confusion. A related idea, loss aversion, helps explain why a nominal cut feels like a loss even when real income is unchanged.