Money Illusion

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Definition: Money Illusion


Money Illusion


Full Definition of Money Illusion


Money illusion refers to perception about changes made to nominal prices, as opposed to real prices. John Maynard Keynes first talked about it, and later on, in 1928, Irving Fisher wrote a book titled Money Illusion. Some economists are of the view that people tend to act rationally when it comes to money and take into account only real prices. But several studies have indicated that money illusion does exist. In 1997, Shafir, Diamond and Tversky empirically proved the existence of money illusion.

Money illusion leads to price stickiness. Nominal prices are often slow to change. This can happen even when real prices have increased due to inflation. Money illusion also influences contracts and laws. Studies have revealed that a 2 per cent drop in nominal income can be perceived as unfair, whereas a 2 per cent increase in nominal income followed by a subsequent 4 per cent increase in inflation can be perceived as fair.

Real income

Real income is calculated after adjusting for inflation. It is arrived at by deducting inflation from nominal income. Real income is a good indicator of purchasing power and general well-being. In the long run, real income does not affect nominal income.

Price Stickiness

Stickiness refers to the tendency of a variable to resist change. Price stickiness can be brought on by money illusion. Apart from money illusion, other factors like menu costs and imperfect information can also lead to price stickiness.

Wages

For workers and labourers, money illusion can lead to acceptance of wages that seem high but are actually low, when accounted for in “real” terms. Thus money illusion can help a firm to hire more workers at low wages, even during a situation of high inflation.

Housing Market Effect

During low inflation, monthly mortgage payments are lower than rent payments. This leads people to purchase a house instead of renting it. But low or decreasing inflation also means higher real costs of future mortgage payments. But money illusion prevents people from appreciating this fact.


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Definition Sources


Definitions for Money Illusion are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 27th March, 2020 | 0 Views.