Money Illusion

AAA

DEFINITION of 'Money Illusion'

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.

INVESTOPEDIA EXPLAINS '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.

RELATED TERMS
  1. Sticky-Down

    A figure that can move higher relatively easily, but only will ...
  2. Nominal

    An unadjusted rate, value or change in value. This type of measure ...
  3. Behavioral Finance

    A field of finance that proposes psychology-based theories to ...
  4. Real Rate Of Return

    The annual percentage return realized on an investment, which ...
  5. Inflation

    The rate at which the general level of prices for goods and services ...
  6. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
RELATED FAQS
  1. What does deflation mean to investors?

    Before we delve right into the topic of deflation, it should be noted that the causes and effects of deflation are complex ... Read Full Answer >>
Related Articles
  1. Economics

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  2. Investing Basics

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  3. Investing Basics

    How Interest Rates Affect The Stock Market

    Whether you're buying lunch, a home or a stock, you're influenced by interest rates.
  4. Options & Futures

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  5. Options & Futures

    Introduction To Inflation-Protected Securities

    Inflation is an enemy to investors - except to those who invest in IPS, which guarantee a real rate of return with no credit risk.
  6. Options & Futures

    Explaining The World Through Macroeconomic Analysis

    From unemployment and inflation to government policy, learn what macroeconomics measures and how it affects everyone.
  7. Economics

    The Importance Of Inflation And GDP

    Learn the underlying theories behind these concepts and what they can mean for your portfolio.
  8. Active Trading Fundamentals

    Behavioral Finance

    Learn the science behind irrational decision making and how you can avoid it.
  9. Investing

    Can Europe’s QE Be A Stimulus For U.S. Investors?

    Finding value in today’s markets has been difficult, so many investors are turning to opportunities outside of the U.S. But where should they look?
  10. Economics

    10 Countries With The Biggest Forex Reserves

    Without adequate reserves, a nation's economy can grind to a halt. Here are the 10 nations with the biggest forex reserves.

You May Also Like

Hot Definitions
  1. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  2. Asset Class

    A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same ...
  3. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  4. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  5. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  6. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
Trading Center