Money Illusion

Abstract

The term “money illusion” refers to a tendency to think in terms of nominal rather than real monetary values. Money illusion has significant implications for economic theory, yet it implies a lack of rationality that is alien to economists. This paper reviews survey questions regarding people's reactions to variations in inflation and prices, designed to shed light on the psychology that underlies money illusion. We propose that people often think about economic transactions in both nominal and real terms, and that money illusion arises from an interaction between these representations, which results in a bias toward a nominal evaluation.