When the number on your pay slip is bigger than last year, anyone feels good. But if grocery prices rose even more in the same year, the bigger paycheck actually buys fewer things. The number grows while the household budget gets tighter, a strange situation indeed. Even so, many people look only at the higher number and feel they are better off. The term that explains this tendency to be fooled by the surface of money is “money illusion.”
Simply put, money illusion means “the mistake of judging gains and losses by the amount written on money, that is, the nominal amount, rather than by its actual purchasing power.” The American economist Irving Fisher gave it its name, and John Maynard Keynes made it widely known.
In this article, we will look in turn at what exactly money illusion gets wrong, the famous survey experiments that demonstrated it, the traces it leaves throughout the economy, and ways to escape this illusion.
Fooled by the Numbers: How Money Illusion Works and What It Does
Nominal Value and Real Value
To understand money illusion, we first need to distinguish between two yardsticks for measuring the value of money.
- Nominal Value: The amount exactly as written on a banknote or bank account. It refers to numbers you can see right away, such as a monthly salary of 3 million won or 3% interest on a deposit.
- Real Value: The amount of goods and services that money can actually buy. When prices rise, the real value falls even if the nominal amount stays the same.
For example, if your salary rose 3% while prices rose 5%, your nominal salary increased but your real salary fell by about 2%. Today’s money is not gold or silver with value in itself, so its actual worth depends on the price level. Money illusion is the habit of judging only by the more visible of these two yardsticks, the nominal amount.
Who Would Be Happier? A Famous Survey Experiment
Whether money illusion really exists was long debated among economists, because some argued that people are rational and ultimately think in real terms.
(1) Ann’s and Barbara’s Salaries
In 1997, Eldar Shafir, Peter Diamond, and Amos Tversky told people the stories of two individuals. Ann got a 2% raise in a year with no inflation, while Barbara got a 5% raise in a year when prices rose 4%.
(2) The Head and the Heart Answered Differently
Asked who was better off in economic terms, 71% chose Ann, whose real income rose 2%. But asked who would be happier, 64% picked Barbara, whose real income rose only 1%. People understood the math, yet their feelings followed the bigger number.
(3) A Wage Cut Versus a Smaller Raise
A 1986 survey by Daniel Kahneman and his colleagues found something similar. With no inflation, 62% said a company cutting wages by 7% was unfair, but with prices rising 12%, only 22% said a company raising wages by just 5% was unfair. The loss of real income was almost the same, yet the reactions differed sharply.
Traces Left Throughout the Economy
Money illusion does not stop at one person’s mood; it leaves clear traces on the economy as a whole.
(1) Prices and Wages That Rarely Change
Because people use nominal amounts as their reference point, companies are very reluctant to cut wages and shops seldom change their price tags. Money illusion is cited as one of the reasons nominal prices don’t move easily even when the price level changes.
(2) Promises That Ignore Inflation
Amounts written in contracts or laws are often not adjusted automatically as prices rise. Rational reasoning says they should be adjusted for inflation far more often than they are, yet they are not.
(3) The Tug-of-War Between Unemployment and Inflation
When prices rise quickly and workers are satisfied with nominal wage increases, companies can keep real wages low and hire more people. This is why money illusion often comes up in explanations of the Phillips Curve, which says inflation and unemployment move in opposite directions.
How to Escape Money Illusion
Money illusion is a mistake anyone who deals with numbers can fall into, so it is wise to prepare in advance with a few habits.
(1) Always Look at Prices Alongside
When you look at a salary increase or deposit interest, subtract the inflation rate for the same period. If interest is 3% but prices rose 4%, the number in your account has grown, but the amount you can actually buy has shrunk.
(2) Be Extra Careful Over Long Periods
Comparing house prices or salaries from decades ago directly with today’s numbers exaggerates the difference. Old amounts should be converted into today’s money, taking into account the price changes in between, to be accurate.
(3) Think in Terms of Quantities of Goods
Instead of the amount of money, try converting it into how many meals or bus fares it can buy, and its real value becomes much clearer. People tend to redo the math only when real value becomes glaringly obvious, such as when prices rise very rapidly or when signing a long-term contract.
Money illusion arises not because people are foolish, but from the natural habit of using the numbers in front of us as a shortcut for judgment. Just remember that this shortcut is not always the right path, and you can weigh your salary, savings, and investments far more accurately.
Thinking first of what money can buy rather than the number in your bank account: that is the first step in economics toward reading the true value of money.
