A situation in which wages increase 2.3% and prices increase 3.1% is equivalent to a situation in which wages fall by 0.8% at constant prices. Though the two scenarios are equivalent in real terms there are people who perceive these situations differently. These people are said to be prone to 'money illusion.'
It has been commonly thought that the impact of irrational behavior is limited in markets because “smart agents” can take advantage of irrational traders. However, recent evidence from the field and the experimental laboratory suggests that money illusion is not limited.
A rational consumer bases shopping decisions on “real” prices (e.g., how many hours do I have to work for a loaf of bread?) and would not change consumption patterns if all nominal prices were to move in proportion. Yet, normal people are often confused by purely nominal changes.
An example of money illusion is confusion of nominal and real interest rates in the housing market.
Housing prices have risen sharply in several countries, and booms followed by busts are common in housing markets. When inflation is low, monthly nominal interest payments on mortgages are low compared to the rent of a similar house. Housing prices therefore seem cheap, causing illusion-prone buyers to buy rather than rent which, in turn, causes an upward pressure on housing prices when inflation declines. However, decreasing inflation also increases the real cost of future mortgage payments.
Investors who base their decision on the salient low nominal mortgage payments but ignore the less visible effect of inflation on the future real mortgage cost are prone to an illusion.
Economists have remained skeptical because field evidence consistent with money illusion may also be consistent with alternative accounts, involving fully rational agents. Such alternative accounts can convincingly be ruled out in the laboratory. Experimental studies complement field studies by investigating simpler markets but under more controlled conditions, allowing researchers to isolate the effect of money illusion.
Experiments conducted by Ernst Fehr (University of Zurich) and Jean-Robert Tyran (University of Copenhagen) show that money illusion can have a profound impact on market prices. In the experiments, decision makers are presented with either real or nominal information on profits under otherwise identical conditions to test the effect of inflating or deflating all nominal values.
The authors find that firms are reluctant to cut nominal prices with deflation in an attempt to avoid lower nominal profits associated with lower price levels, but are much less reluctant to increase nominal prices with inflation.
The studies also show that money illusion has stronger effects on market prices when rational agents have incentives to “follow the crowd” rather than to “go against the tide”, i.e. when they compensate the choices of those prone to money illusion.
Source: University of Copenhagen