Money Illusion

Money illusion is the tendency to think of money in nominal terms (face value) rather than in real terms (value after adjusting for inflation). In other words, people often treat a dollar today as if it has the same purchasing power it had previously, ignoring changes in prices.

Key takeaways
* Money illusion leads people to over- or under‑estimate their real wealth when inflation is present.
* It helps explain why nominal wage increases can feel satisfying even when real wages fall.
* Behavioral factors (limited financial literacy, attention to nominal prices) and price stickiness contribute to money illusion.
* Recognizing the difference between nominal and real values is essential for accurate financial decisions.

Nominal vs. real values
* Nominal value: the stated dollar amount — wages, prices, or income measured at current prices.
* Real value: the purchasing power of that amount after adjusting for inflation (commonly using a price index such as the CPI).

Why it matters
People who suffer money illusion may:
* Accept nominal wage increases that do not improve, or even reduce, their purchasing power.
* Misjudge the fairness of pay changes (e.g., view a nominal pay cut as unfair even if real pay is unchanged, or view a small nominal raise as fair despite higher inflation).
* Make suboptimal saving, investing, or spending decisions because they overlook inflation’s effect on real returns and costs.

Causes
* Limited financial literacy or inattention to inflation.
* Salience of nominal prices — consumers see sticker prices and paycheck amounts more readily than inflation-adjusted figures.
* Price stickiness: some prices adjust slowly, so people may not immediately perceive changes in real wages or costs.

History and key figures
The term “money illusion” was coined by Irving Fisher and later popularized by John Maynard Keynes. The concept remains debated: some economists argue people naturally consider real values because they observe price changes, while others point to persistent behavioral evidence of money illusion.

Example
An employee earning $25,000 receives a 3% nominal raise (+$750). If inflation is 5%, the employee’s real purchasing power falls despite the higher nominal pay. The raise feels like an improvement nominally, but after adjusting for prices it is a decline.

Relation to macroeconomics: the Phillips curve
Money illusion is important in explanations of the Phillips curve, which links inflation, economic growth, and unemployment. If workers misperceive nominal wage rises as real gains, employers can hire more cheaply, temporarily reducing unemployment. Over time, as real wages and prices adjust and perceptions update, unemployment returns to its natural rate. Modeling this mechanism often requires additional assumptions about price and wage adjustment speeds and information asymmetries between employers and workers.

How to avoid money illusion
* Always compare nominal figures on a consistent, inflation‑adjusted basis (use real terms).
* Use price indices (CPI or other relevant deflators) to convert nominal wages, returns, or costs into real values.
* Consider indexing contracts, wages, or savings to inflation to preserve purchasing power.
* Track real returns on investments (nominal return minus inflation) rather than nominal returns alone.
* Increase financial literacy about inflation and purchasing power when making budgeting or long‑term financial decisions.

Conclusion
Money illusion is a common behavioral bias: people focus on nominal amounts and overlook changes in purchasing power caused by inflation. By understanding and adjusting for inflation — converting nominal values into real terms — individuals and policymakers can make better-informed decisions about wages, prices, saving, and economic policy.