Money Illusion

What is money Illusion’

Money illusion in economic theory stating that many people have an illusory picture of their wealth and income based on nominal dollar terms, not real terms. Real prices and income take into account the level of inflation in the economy.

Penetration of money Illusion’

Money illusion is a psychological matter that is debated among economists. Some feel that people automatically think of their money in real terms, based on the prices on things that they see around them. However, there are several reasons why the money illusion, is likely to exist for many people, including a General lack of financial education, and price stickiness seen in many goods and services.

This term is attributed to the famous economist John Maynard Keynes. Money illusion is often cited as a reason why small levels of inflation (1 to 2 percent per year) is actually desirable for the economy. Having small levels of inflation allows employers, for example, to modestly raise wages in nominal terms did not actually pay more in real terms. As a result, many people who get a raise, consider that their wealth is growing, regardless of the actual level of inflation.

It is interesting to note that money illusion color people’s perceptions of financial results. For example, experiments have shown that people generally perceive a 2% of salary in nominal income, without any changes in monetary value as unfair. However, they also perceive a 2% rise in nominal income where there is 4% inflation as fair.

The illusion of money and the Phillips curve

Money illusion is one of the key aspects in the Friedmanian version of the Phillips Curve. However, money illusion is not adequate to explain the mechanism at work in the Phillips Curve. This requires two additional assumptions. First, prices respond differently to changing conditions of demand: the growth in aggregate demand affect commodity prices before it affects the prices in the labor market. Thus, the fall in unemployment, in the end, the result of a decline in real wages and accurate judgment on the situation of workers is the only reason to return to the original (natural) level of unemployment (i.e. at the end of the money illusion, when they finally recognize the actual dynamics of prices and wages).

Another (arbitrary) assumption refers specifically to the special information asymmetry: anything that a person does not know in connection with changes in (real and nominal) wages and prices, can be clearly observed by employers. New classical version of the Phillips curve was aimed at eliminating confusion additional assumptions, but its mechanism still requires money illusion

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