Monetary Illusion

Money illusion, a cognitive bias in economics, is when money is perceived in its face value (nominal) rather than its actual purchasing power (real). This misperception stems from the lack of intrinsic value in modern fiat currencies, whose real value depends on the price level. Coined by Irving Fisher, popularized by John Maynard Keynes, and supported by empirical evidence, money illusion affects behavior, including price stickiness and perceptions of fairness in income changes amidst inflation. It also plays a role in the Phillips curve, suggesting that people may accept seemingly higher wages during inflation, influencing hiring. However, it requires additional assumptions to fully explain this relationship.

According to the 1997 paper “Money Illusion” by Eldar Shafir, Peter Diamond, and Amos Tversky in The Quarterly Journal Of Economics, they state that money illusion has significant implications for economic theory. However, it implies a lack of rationality that is alien to economists. The term “money illusion” refers to a tendency to think in terms of nominal rather than real monetary values.

The Value of Money

What is meant by the term ‘value of money’? One common way to define it is as the reciprocal of the price level:

value of money = 1/price level.