Behavioral Economics: Money Illusion

A short topic this week, but an important one nonetheless. Money Illusion refers to the tendency of people to think of currency in nominal terms (its face value), rather than real terms (its purchasing power).

Consider the following question presented to people:

Suppose Adam, Ben, and Carl each received an inheritance of $200,000, and each used it immediately to purchase a house. Suppose that each of them sold the house a year after buying it. Economic conditions, however, were different in each case:

• When Adam owned the house, there was a 25% deflation. A year after Adam bought the house, he sold it for $154,000 (23% less than he paid).
• When Ben owned the house, there was no inflation or deflation. He sold the house for $198,000 (1% less than he paid for it).
• When Carl owned the house, there was a 25% inflation. A year after he bought the house, Carl sold it for $246,000 (23% more than he paid).

Please rank Adam, Ben, and Carl in terms of the success of their house transactions.

Looking at this nominally, or at face value, it would appear that Carl did the best, selling the house for 23% higher than it was originally worth. However, looking at the real values, Carl really lost 2%, while Adam did the best, gaining 2%. The participants of the study were confused as well, the majority of the people thinking Carl did the best.

This is just a small example of a way Money Illusion can affect rational judgment. In fact, according to Investopedia, “Money illusion is often cited as a reason why small levels of inflation 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.”

Why are people’s reactions so easily determined by the nominal change in value? One reason is that it can quite simply be attributed to a general lack of financial education. So, next time you are making a purchase or gauging your reaction to a change in monetary values, don’t fall victim to Money Illusion!

To read more about Money Illusion, click here.