Editing Money illusion

{{Short description|Cognitive bias in economics}}
In [[economics]], '''money illusion''', or '''price illusion''', is a [[cognitive bias]] where [[money]] is thought of in [[real versus nominal value (economics)|nominal, rather than real]] terms. In other words, the face value (nominal value) of money is mistaken for its [[purchasing power]] (real value) at a previous point in time. Viewing purchasing power as measured by the nominal value is false, as modern [[fiat currency|fiat currencies]] have no intrinsic value and their real value depends purely on the [[Consumer Price Index|price level]]. The term was coined by [[Irving Fisher]] in ''Stabilizing the Dollar''. It was popularized by [[John Maynard Keynes]] in the early twentieth century, and [[Irving Fisher]] wrote an important book on the subject, ''The Money Illusion'', in 1928.<ref>{{Citation | title = The Money Illusion | last = Fisher | first = Irving | publisher = Adelphi Company | year = 1928 |location=New York }}</ref>

The existence of money illusion is disputed by [[monetary]] economists  who contend that people act rationally (i.e. think in real prices) with regard to their wealth.<ref name=poverty>{{cite journal|author1=Marianne Bertran |author2=Sendhil Mullainathan |author3=Eldar Shafir  |name-list-style=amp |title=A behavioral-economics view of poverty|journal=The American Economic Review|date=May 2004|volume=94|issue=2|pages=419–423|jstor=3592921|doi=10.1257/0002828041302019|s2cid=2865749 |url=https://dash.harvard.edu/bitstream/1/2907437/2/behav%20econ%20poverty.pdf }}</ref> [[Eldar Shafir]], [[Peter A. Diamond]], and [[Amos Tversky]] (1997) have provided  [[empirical evidence]] for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations.<ref name="Shafir">{{Citation |last1=Shafir |first1=E. |last2=Diamond |first2=P. A. |last3=Tversky |first3=A. |year=1997 |title=On Money Illusion |journal=Quarterly Journal of Economics |volume=112 |issue=2 |pages=341–374 |doi=10.1162/003355397555208 }}</ref>

Shafir et al.<ref name="Shafir" /> also state that money illusion influences economic behaviour in three main ways:

*[[Sticky (economics)|Price stickiness]]. Money illusion has been proposed as one reason why [[nominal price]]s are slow to change even where [[Inflation (economics)|inflation]] has caused [[real price]]s to fall or costs to rise.
*[[Contracts]] and [[laws]] are not indexed to inflation as frequently as one would rationally expect.
*Social discourse, in formal media and more generally, reflects some confusion about [[Real versus nominal value (economics)|real and nominal value]].

Money illusion can also influence people's perceptions of outcomes. Experiments have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. This result is consistent with the 'Myopic Loss Aversion theory'.<ref>{{Cite journal | last1 = Benartzi | first1 = Shlomo | last2 = Thaler | first2 = Richard H. | year = 1995 | title = Myopic Loss Aversion and the Equity Premium Puzzle | journal = [[Quarterly Journal of Economics]] | volume = 110 | issue = 1 | pages = 73–92 | jstor = 2118511 | doi = 10.2307/2118511| citeseerx = 10.1.1.353.2566 | s2cid = 55030273 }}</ref> Furthermore, the money illusion means nominal changes in price can influence demand even if real prices have remained constant.<ref>{{citation
|title=The Chicago Tradition, The Quantity Theory, And Friedman
|first=Don|last= Patinkin
|journal=Journal of Money, Credit and Banking
|volume= 1|issue= 1 |year= 1969|pages= 46–70
|jstor=1991376
|doi=10.2307/1991376}}
</ref>

==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>

==See also==
{{Portal|Numismatics}}
*[[Behavioural economics]]
*[[Fiscal Illusion]]
*[[Framing (social science)]]
*[[Homo economicus]]
*[[Map-territory relation]]

==References==
{{Reflist}}

==Further reading==
*{{Citation |last1=Fehr |first1=Ernst |author-link=Ernst Fehr |last2=Tyran |first2=Jean-Robert |year=2001 |title=Does Money Illusion Matter? |journal=American Economic Review |volume=91 |issue=5 |pages=1239–1262 |jstor=2677924 |doi=10.1257/aer.91.5.1239 |hdl=20.500.11850/146556 |s2cid=15342301 |url=https://www.zora.uzh.ch/id/eprint/95345/1/Does_Money_Illusion_Matter.pdf }}
*{{Citation |last=Howitt |first=P. |chapter=money illusion |title=The New Palgrave: A Dictionary of Economics |volume=3 |year=1987 |publisher=Macmillan |location=London |isbn=978-0-333-37235-7 |pages=518–519 }}
*{{Citation |last1=Weber |first1=Bernd |last2=Rangel |first2=Antonio |last3=Wibral |first3=Matthias |last4=Falk |first4=Armin |year=2009 |title=The medial prefrontal cortex exhibits money illusion |journal=[[Proceedings of the National Academy of Sciences|PNAS]] |volume=106 |issue=13 |pages=5025–5028 |doi=10.1073/pnas.0901490106 |pmid=19307555 |pmc=2664018 |bibcode=2009PNAS..106.5025W |doi-access=free }}
*{{Citation |last1=Akerlof |first1=George A. |last2=Shiller |first2=Robert J. |year=2009 |publisher=Princeton University Press |title=Animal Spirits |pages=41–50 |url=http://press.princeton.edu/titles/8967.html |isbn=9780691142333 }}
* Thaler, Richard H.(1997) [http://faculty.chicagobooth.edu/richard.thaler/research/pdf/IrvingFisher.pdf "Irving Fisher: Modern Behavioral Economist"] in ''The American Economic Review'' Vol 87, No 2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Association (May, 1997)
*[[Huw Dixon]] (2008), [http://www.dictionaryofeconomics.com/article?id=pde2008_N000166 New Keynesian Economics], New Palgrave Dictionary of Economics [http://www.cardiff.ac.uk/carbs/econ/workingpapers/papers/E2007_3.pdf New Keynesian macroeconomics].

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[[Category:Heuristics]]
[[Category:Inflation]]
[[Category:Behavioral finance]]
[[Category:Cognitive biases]]