What is... | December 23, 2009

What is the money illusion?

Despite the title, the money illusion is firmly based in reality.

The money illusion is a tendency to think of the face value of money rather than its actual worth. This happens more often and is more important than many may think. For instance, it can distort your view of a pay rise.

Experiments have shown that, in general, people think a cut of two percent from their wages is unfair. Perhaps the finding is not surprising. But the same research showed that people tend to see a two percent rise in nominal income as fair even if inflation is running at four percent. The two scenarios are what economists would describe as “almost rational equivalents” – or almost the same. 

All things are not equal
A dramatic example of money illusion was seen when countries adopted the euro. It was perhaps a little like the trouble some holidaymakers have with calculating their spending while in a country with a different currency. An experiment in the Netherlands showed soon after the country adopted the euro, charity donations rose markedly. 

The study – published in the Journal of Money, Credit and Banking in 2004 – showed in “pre-euro” years, donations from 7,500 homes to a particular charity did not grow by more than the rate of inflation but the year the Eurozone common currency was introduced, donations surged by 11%. 

The explanation? Money illusion. The guilder-euro exchange rate was 2.20 guilders to one euro when the common currency was introduced in the Netherlands in 2002. But it was possible people tended to simply divide old prices by 2 – rather than 2.2 – hence the 11% hike in donations. While money illusion might sound otherworldly or complicated, it’s got plenty of practical applications. It could pay to think about the real buying power of money at your next pay round or when you give to charity.

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eZonomics team
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