What is 'Money Illusion'
Money illusion is an economic theory stating that many people have an illusory picture of their wealth and income based on nominal dollar terms, rather than real terms. Real prices and income take into account the level of inflation in an economy.
BREAKING DOWN 'Money Illusion'
Money illusion is a psychological matter that is debated among economists. Some feel that people automatically think of their money in real terms, based on the prices of things they see around them. However, there are several reasons why the money illusion likely exists for many people, including a general lack of financial education, and the price stickiness seen in many goods and services.
This term is attributed to noted economist John Maynard Keynes. Money illusion is often cited as a reason why small levels of inflation (1-2% per year) are actually desirable for an economy. Having small levels of inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.