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According to the money illusion theory, people tend to see their wealth and income in nominal dollar terms rather than in actual dollar ones. To put it another way, it is considered that individuals do not consider the degree of inflation in an economy, erroneously assuming that a dollar is worth the same as it was the year before.
The rate of inflation may be rather erratic and unpredictable. Take, for example, the years 1964 to 1983 in the United States. The inflation rate soared from 1.3 percent in 1964 to 5.9 percent in 1970, then to 14 percent in 1980, before falling to 3 percent in 1983. People were taken off guard by these sudden shifts, which were nonetheless rather low in terms of inflation. Inflation rates in Peru were much more volatile from the late 1980s to the early 1990s. With an inflation rate of 77 percent in 1986, it was already pretty high. By 1990, however, it had risen to 7,500 percent, only to drop to 73 percent two years later.
Money illusion, often known as price illusion, is an economic hypothesis stating that people tend to think of their income and wealth in nominal rather than real terms. Another approach to thinking about the money illusion is that people do not account for the impacts of inflation on their money, so they mistakenly believe their acquired wealth is worth the same as it was the year before.
In 1928, economist Irving Fisher published the book "The Money Illusion." Fisher's book told the story of a German shopkeeper when Germany's currency (at the time, the German mark, not the euro) was depreciating rapidly due to hyperinflation. Hyperinflation is a situation where inflation is extremely high and rapidly increasing; Germany had one after World War 1.
The shopkeeper believed she was making a profit since she was selling shirts for more than she paid for them. According to Fisher, however, the shopkeeper made less money or perhaps lost money when she sold her clothing. Because of inflationary pressures, the shopkeeper's purchasing power, or the number of products and services she could buy with the same amount of money, had decreased.
Fisher concluded that individuals think about their money in nominal terms rather than actual terms, giving them a false sense of security about their riches. In his book "Stabilizing the Dollar," American economist Irving Fisher created the phrase "money illusion." Fisher went on to write a full book about the subject, titled "The Money Illusion," in 1928.
Money illusion is a psychological issue that economists dispute. Some argue that because individuals observe price increases every time they visit a business, they instinctively conceive of their money in real terms, compensating for inflation.
Meanwhile, other economists believe that money illusion is rampant, citing factors including a lack of financial knowledge and the price stickiness observed in many goods and services as reasons why individuals can fall into the trap of disregarding growing living costs.
The money illusion is sometimes given as a reason why low levels of inflation-1% to 2% per year-are beneficial to an economy. Low inflation, for example, permits companies to boost salaries somewhat in nominal terms without paying more in real ones. As a result, regardless of the real inflation rate, many people who receive wage rises think that their wealth is growing.
Money illusion, in particular, colors people's views of financial outcomes. Experiments have demonstrated that a 2% pay decrease in nominal income with no change in monetary value is perceived as unjust by most respondents. They do, however, consider a 2% increase in nominal income to be reasonable while inflation is at 4%. Individuals wrongly believe in increasing their wealth, but they do not account for inflation, resulting in the money illusion. As a result of this reality, and assuming that inflation remains positive, an individual's wealth will frequently be exaggerated.
Economists frequently cite money illusion as a major reason why inflation is beneficial to the economy. Specifically:
Stickiness in pricing. Firms may be hesitant to change pricing based on costs since raising prices is a psychological blow. Consumers want steady pricing, and rising costs might create uncertainty and deter spending.
Failure to recognize the difference between nominal and actual values. For example, suppose a government brags about spending record amounts on the healthcare system. In that case, it's not immediately apparent that this may include inflationary impacts and result in a lesser actual rise. Another example may be the rise or fall in home values. The nominal house price may be compared more simply than the inflation-adjusted house price.
The shift in nominal housing prices from 1975 to now is lb7,000 to lb200,000, a considerably more shocking statistic. The change in real estate values is less dramatic, ranging from lb100,000 to lb220,000.
Workers are likely to resist nominal wage cuts even in a period of deflation (falling prices) because of the psychological cost of seeing nominal earnings decline. As a result, real wage unemployment (unemployment induced by wages above the equilibrium) might occur in a deflationary phase.
According to behavioral economics, visible losses have a greater impact than unseen losses, as an example. A real pay decrease of 2% is achieved if prices rise by 4% and wages grow by 2%. A real pay drop of 2% is achieved if prices rise by 0% and wages fall by 2%.
People do not do accurate calculations in everyday life instead of relying on basic rules of thumb to save time. As a result, seeing money as a continual source of worth simplifies life. As a result, many think that $100 has a fixed worth and ignore the minor impacts of inflation.
There is some information that is missing. People may easily perceive their nominal wage, but calculating wages takes an understanding of price movements and real value calculations. Inflation is not directly tied to contracts. Contracts frequently strive to maintain pricing the same because people detest price fluctuations.
Underestimating the rate of inflation is a common mistake. Some nations have attempted to lower the official inflation rate to deceive the public about the state of pricing. In Argentina, for example, the official rate of inflation was 15 percent in 2015, while private analysts estimated it to be closer to 28 percent. Consumers would overestimate their purchasing power if they relied on real expenditure on official inflation.
According to monetarist economists like Milton Friedman, money illusion occurs exclusively in the short term, when there is a time lag before consumers realize prices have increased.
Because money illusion occurs in the short term, expanding the money supply might temporarily increase actual production. People spend more as a result of the increasing money supply, leading aggregate demand to rise. As the money supply expands, so do nominal salaries, and employees agree to offer more labor, increasing the short-run aggregate supply. However, workers eventually realized that the salary boost was simply a stipend - since prices had increased. As a result, in the long run, employees reduce overtime and output recovers to its original level.
Because of this money illusion, increasing the money supply might result in a temporary reduction in unemployment. In the long run, however, unemployment remains at its normal level.
Some economists are skeptical of the concept of money illusion. They claim that while individuals may be mistaken at times, society as a whole is not. They are, on average, correct in the long run. As a result, if the money supply grows, employees will not be tricked into believing that nominal gains are actual increases. According to rational expectations, workers have a greater understanding of pricing than some economists give them credit for. John F. Muth popularized the concept of rational expectations, which he championed.
When the same objective situation is conveyed in nominal terms rather than actual terms, it causes people to behave differently. This research demonstrates that seemingly insignificant variations in payment representation lead to significant differences in nominal price inertia, demonstrating the behavioral impact of money illusion. Price expectations and actual price choices following a fully expected negative nominal shock are stickier when payoff information is supplied in nominal terms than when payoff information is presented in real terms. Furthermore, we demonstrate that money illusion leads to asymmetric impacts of negative and positive nominal shocks. After a negative shock, nominal inertia is relatively large and long-lasting, whereas it is quite minor after a positive shock.