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 to 2 percent 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.

It's interesting to note how money illusion colors people's perceptions of financial outcomes. For example, experiments have shown that people generally perceive a 2 percent pay cut in nominal income with no change in monetary value as unfair. However, they also perceive a 2 percent rise in nominal income, where there is 4 percent inflation, as fair. 

The Money Illusion and The Phillips Curve

Money illusion is understood to be a key aspect in the Friedmanian version of the Phillips Curve. However, money illusion doesn't adequately account for the mechanism at work in the Phillips Curve. To do so requires two additional assumptions. First, prices respond differently to modified demand conditions: an increase in aggregate demand affects commodity prices sooner than it affects labor market prices. Thus, a drop in unemployment is, after all, an outcome of decreasing real wages and an accurate judgment of the situation by employees is the only reason for the return to an initial (natural) rate of unemployment (i.e. the end of the money illusion, when they finally recognize the actual dynamics of prices and wages).

The other (arbitrary) assumption relates specifically to special informational asymmetry: whatever employees are unaware of, in connection with the changes in (real and nominal) wages and prices, can be clearly observed by employers. The new classical version of the Phillips Curve was aimed at removing the puzzling additional presumptions, but its mechanism still requires money illusion