Behavioral Bias: The Money Illusion
Bias: The Money Illusion
Quick Definition: (Via Wikipedia)
In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is a fallacy as modern fiat currencies have no inherent value and their real value is derived from their ability to be exchanged for goods and used for payment of taxes.
Extended Definition: (Via Behavioral Finance Net)
“Frame dependence also impacts the way that people deal with inflation, both cognitively and emotionally. This is the issue of money illusion.” Shefrin (2000)
How This Bias Relates To You(Via Wikipedia)
It has been contended that money illusion influences economic behaviour in three main ways:
1. Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
2. Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
3. Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.
Money illusion can also influence people’s perceptions of outcomes. Experiments have shown that people generally perceive a 2% cut in nominal income as unfair, but see a 2% rise in nominal income where there is 4% inflation as fair, despite them being almost rational equivalents. Further, money illusion means nominal changes in price can influence demand even if real prices have remained constant (Patinkin, 1969).
The money illusion is one of my favorite illusions . I see people succumb to it every day-especially in the area of personal finance. I think its important to create a set of accounting statements that are adjusted for inflation. I practice this idea with my investments and it has worked to my advantage.
Additional Papers & Research On The Money Illusion:
1. Does money illusion matter? – Via E Collection
2. The medial prefrontal cortex exhibits money illusion – Via Pnas
3. Money Illusion & The Aggregate Consumption Function – Via JSTOR
4. Money Illusion & Demand Analysis – Via Jstor