Why does foreign money often feel like play money to travelers" Just in time for summer vacation season, an important new study from the June issue of the Journal of Consumer Research examines why spending patterns abroad deviate so much from what we spend at home.

Klaus Wertenbroch (INSEAD, France), Dilip Soman (University of Toronto), and Amitava Chattopadhyay (INSEAD, Singapore) argue that problems arise from a fundamental mistake in how people perceive the value of currency, known as money illusion. The numerical value printed on a bill affects our perceptions of its real purchasing power, biasing consumer judgment during periods of inflation or when using foreign currencies. It may also have serious macroeconomic consequences as shown by European consumers’ price perceptions during the change in 2002 from national currencies to the euro, the authors point out.

“We examine the psychological processes involved in evaluating transactions in foreign currencies,” write Wertenbroch and his coauthors. “Our findings … explain to marketers how currency denominations affect real spending or private label market shares.”

In several laboratory experiments, the researchers gave participants in Hong Kong, the United States, and Germany a budget in a foreign or domestic currency and asked them how much they would spend on various transactions. They found that people spent less in real terms when the face value of the foreign currency is less than that of their home currency (e.g., for a U.S. consumer in Europe, US$ 1= € 0.80). Conversely, when the face value of the foreign currency is higher (e.g., for a U.S. consumer in Japan, US$ 1= ¥ 120), consumers spent more.

“In other words, consumers underspend when using less numerous currencies than their home currency, and they overspend when using more numerous currencies. We show that this occurs because people evaluate transactions by estimating the nominal difference between their budget and the price of a given good or between prices of competing goods,” the researchers explain.

Additionally, they found that people’s willingness to gamble almost doubled when the researchers increased the face value of the currency in which they placed their bets by a factor of 100 – even if the actual potential payoff was held constant.

Klaus Wertenbroch, Dilip Soman, and Amitava Chattopadhyay, “On the Perceived Value of Money: The Reference Dependence of Currency Numerosity Effects.” Journal of Consumer Research: June 2007.