Editing Money illusion (section)

==Explanations and implications==

Explanations of money illusion generally describe the phenomenon in terms of [[heuristics]]. Nominal prices provide a convenient rule of thumb for determining value and real prices are only calculated if they seem highly [[Salience (communication)|salient]] (e.g. in periods of [[hyperinflation]] or in long term contracts).

Some have suggested that money illusion implies that the negative relationship between inflation and unemployment described by the [[Phillips curve]] might hold, contrary to more recent [[macroeconomic]] theories such as the "expectations-augmented Phillips curve".<ref>{{citation|title=Advanced macroeconomics
|first=David|last= Romer
|publisher=McGraw-Hill|year= 2006|page=252|isbn=9780072877304}}</ref> If workers use their nominal wage as a reference point when evaluating wage offers, firms can keep real wages relatively lower in a period of high inflation as workers accept the seemingly high nominal wage increase. These lower real wages would allow firms to hire more workers in periods of high inflation.

Money illusion is believed to be instrumental in the Friedmanian version of the [[Phillips curve]]. Actually, money illusion is not enough to explain the mechanism underlying this Phillips curve. It requires two additional assumptions. First, prices respond differently to modified demand conditions: an increased aggregate demand exerts its influence on commodity prices sooner than it does on labour market prices. Therefore, the drop in unemployment is, after all, the result of decreasing real wages and an accurate judgement of the situation by employees is the only reason for the return to an initial (natural) rate of unemployment (i.e. the end of the money illusion, when they finally recognize the actual dynamics of prices and wages). The other (arbitrary) assumption refers to a special informational asymmetry: whatever employees are unaware of in connection with the changes in (real and nominal) wages and prices can be clearly observed by employers. The new classical version of the Phillips curve was aimed at removing the puzzling additional presumptions, but its mechanism still requires money illusion.<ref>{{cite book |last=Galbács |first=Peter |title=The Theory of New Classical Macroeconomics. A Positive Critique |location=Heidelberg/New York/Dordrecht/London |publisher=Springer |year=2015 |isbn= 978-3-319-17578-2 |doi=10.1007/978-3-319-17578-2 |series=Contributions to Economics }}</ref>