Money Illusion
Candlefocus EditorAt its most basic level, money illusion stems from the fact that people perceive economic situations in terms of the nominal dollar sums involved, not the real underlying value. This behavior occurs even if the nominal value of goods and services has been affected by inflation or deflation. For example, an individual may take into account that a good will cost them $20 and, thus, neglect to recognize that, in reality, that same $20 is worth less than it was previously. The opposite side of this equation is when an individual perceives their wages to be higher than they actually are due to inflation, when, in reality, their income is lower in real terms.
In recent years, economists have suggested that a lack of financial education, as well as the 'price stickiness' seen in many markets, has been a trigger for money illusion. In one example, employers may take advantage of this phenomenon by offering nominal wage increases without actually providing a real, tangible value increase. This can result in decreased purchasing power for individuals that is not easily noticed, as their salary looks the same on paper.
Ultimately, the effects of money illusion can be seen in many forms, from individuals perceiving increases in purchasing power, to employers understanding the purpose of price stickiness. As such, it can result in a variety of misinformed economic decisions, with potentially profound implications. Recognizing the phenomenon of money illusion is essential in understanding the economics of any given situation.