When the effects of inflation are ignored and it is believed that money has a fixed value, it is termed as money illusion. And due to this illusion at times of inflation, individuals may misconstrue that a higher welfare has been realised due to an increase in nominal income. This however is an illusion as there is no change in the actual or real spending power as there is no difference in the increased rate of change in prices and wages.
For example, the workers may feel that there will be an increase in the standard of living because of a 5% increase in their salary as their income has now increased. However, if the rate of inflation is 7% which means the prices are increasing at a faster pace as compared to the increase in income, the effective purchasing power will fall and the real wages will be down by 2%.
If there is a cut of 1% in the salary of the workers, then workers feel low psychologically. However, when there is a decrease of 2% in the prices then irrespective of their pay cut, their effective income increases by 1%. Even if there is a pay cut, they can still purchase more goods and services than before. This however might not look credible instantly. Initially people might desire for increase of 5% in their wages compared to a wage cut of 1%.
Origin of the term:
Irving Fisher was the first to create this time money illusion concept. As per him price rise and money illusion combination could be detrimental to the economy. However, this concept of money illusion was actually made popular by John Maynard Keynes.
What are the various reasons for money illusion:
- Price Stickiness: As there is a psychological blow in raising prices so firms may not be willing to change prices as per costs. Consumers usually opt for stable prices and when there is a price rise the consumption pattern is discouraged due to uncertainty.
- Failure to distinguish between Nominal and Real values: It is not obvious when government declares that record levels of money has been pumped into health care system as it might not have included effects of inflation and thus might represent only a smaller real increase. Another example is change in the property prices; it is easier to compare nominal house price than the inflation adjusted price.
- Wage Stickiness: During the period of deflation, the workers might not like the idea of a wage cut as that is associated with the psychological perception of a fall in nominal wages. Thus, in a period of deflation, we can end up with real wage unemployment – unemployment caused by wages above the equilibrium.
- Myopic Loss Aversion: Behavioural economists suggest that the visible losses affect people more than the invisible losses. For example,
A) If there is a 4% rise in price and if there is a 2% increase in wage then the real wage cut is actually 2%.
B) If there is no rise price and if there is a 2% cut in wage then the real wage cut is actually 2%.
Research suggests that people perceive A is better off than B even if the outcome is same.
- Lacking precise calculation: In day to day life people fail to make precise calculation and use approximate rules of thumb so as to save time. In the process they view money as something that is a constant source of value which makes life easier. And because of which they consider that a £100 has a constant value and hence they don’t take the small effects of inflation into consideration.
- Missing information: Nominal wages can be easily seen by people, but the knowledge of price changes and calculation of real values is required to know real wages.
- Contracts are not closely linked to inflation: As there is a dislike for price changes, contracts usually help to keep the prices same.
- Underestimating the rate of inflation: Misleading impression is given by some countries. For example: In the year 2015, Argentina had an inflation rate of almost 28% which was stated by the government as 15%. Such reduction in the rate can actually mislead the consumers making them believe that they have higher spending power.
Real and Nominal terms:
Money illusion can be understood by knowing the difference between nominal and real value.
Nominal value takes into account the current monetary value whereas the real value takes into account the effects of inflation.
Nominal value presents the current headline monetary figure whereas real value provides a guide to actual purchasing power and the opportunity cost of workers.
If there is an 8% increase in nominal wages with 6.5% inflation, then the real wage increase in 1.5%
If the nominal interest rate is 3% and the inflation is 2% then the real interest is 1%
Money illusion and adaptive expectations:
Monerarist economists believe that money illusion is short term and where there is a time lag before consumers realise prices have increased.
A temporary increase in real output is caused due to an increase in money supply as money illusion exists in the short run. A rise in aggregate demand is caused because of an increase in money supply and people respond to it. An increase in nominal wages is observed due to rise in money supply and hence more labour is supplied by the workers and there is an increase along the short-run aggregate supply. And in the process workers realise that the prices have actually risen and that the increase in wages was only a nominal increase. And in the long run workers don’t do overtime and the output returns to the same real output.
Monetarist Phillips curve:
Short term fall in unemployment is seen because of increase in money supply because of money illusion.
However, in the long-run, unemployment remains at the natural rate. And the expectations are rational in nature as there is no money illusion.
Some economists are of the opinion that there is no money illusion. As per them, individuals might not always be wrong.