PsychologicalDUAL-USE

Money Illusion

What it is

The tendency to think about money in nominal terms — face-value dollars — rather than in real terms of what it buys, so that inflation and deflation distort judgments of raises, prices, gains, and losses.

How it works

Irving Fisher gave the phenomenon its name in 1928, and Shafir, Diamond and Tversky (1997) showed how it works in ordinary judgment. Asked about Ann, who received a two percent raise during zero inflation, and Barbara, who received a five percent raise during four percent inflation, most respondents correctly said Ann was better off — and then said Barbara was happier and Ann more likely to quit. People know the difference between nominal and real; they just cannot stop the nominal figure from driving the feeling. The same respondents preferred selling a house at a nominal gain that was a real loss over a nominal loss that was a real gain. Fehr and Tyran (2001) showed the illusion has market consequences, slowing price adjustment after a monetary shock. Its persuasive uses follow. Employers hold nominal pay flat during inflation and call it “no cuts”, since workers resist nominal cuts far more than equivalent real ones (Bewley, 1999); governments and oppositions each pick the nominal or real series that flatters them; sellers announce “record” revenues and box-office totals unadjusted for prices; shrinkflation keeps the nominal price and shrinks the product, because the number is what customers watch.

Real-world examples

  • •Shafir, Diamond and Tversky (1997): most respondents knew that a two percent raise with no inflation beats a five percent raise with four percent inflation, yet judged the recipient of the larger nominal raise happier and the recipient of the better real raise more likely to quit.
  • •Bewley's interviews with several hundred managers during the early-1990s recession found firms would lay people off before cutting nominal pay, because a visible pay cut destroyed morale in a way an inflation-eroded wage did not; the same asymmetry lets employers deliver real cuts silently in inflationary years.
  • •During the 2021-2023 US inflation, the administration emphasized nominal wage growth while critics emphasized the sticker prices of groceries and fuel; in the Reagan years supporters quoted nominal income growth while critics cited stagnant real wages. Each side reaches for the series that flatters it, and the audience rarely asks which one is real.
  • •“Highest-grossing film of all time” headlines compare unadjusted box office across decades; in inflation-adjusted terms Gone with the Wind (1939) remains ahead of most modern record-setters, a fact the headlines omit because the nominal record is the story.
  • •In 2016 Mondelez widened the gaps between the peaks of Toblerone bars sold in the UK, cutting the weight from 170 to 150 grams at an unchanged price; the manufacturer knew a nominal price rise is noticed and resented while a quantity cut at a fixed price mostly is not.

Ethical guidelines

Where the line is

Quoting a nominal figure is honest when the real figure is given alongside it or points the same way; the line is crossed when a raise, price, return, or record is presented in whichever terms — nominal or real — hide what has actually happened to purchasing power.

  • ●Report raises, returns, and growth in real terms, or give the inflation rate alongside the nominal figure so the audience can do the subtraction.
  • ●Do not call a real pay cut “no cut” or a real price rise “the same price”; if the quantity or the purchasing power has changed, the price has changed.
  • ●When you cite a “record”, state whether it is adjusted for inflation; a nominal record in an inflationary year is close to automatic.
  • ●Using a nominal figure because it is the one your audience recognizes is acceptable when the real figure points the same way; choosing it because the real figure points the other way is deception.

How to defend against it

  • ►Ask “in real terms?” of every raise, return, budget, and record — and if the speaker cannot answer, subtract the inflation rate yourself.
  • ►Compare your pay change to the consumer price index each year; a raise below it is a cut, whatever it is called.
  • ►For any “highest ever” or “record” claim, run the figures through an inflation calculator before being impressed; the Bureau of Labor Statistics and most central banks publish one.
  • ►Watch unit prices rather than pack prices; shrinkflation hides in the weight, not in the number on the shelf tag.
  • ►When a politician or executive quotes a series, ask which series they would have quoted if the numbers were reversed.

References

  1. Shafir, E., Diamond, P., & Tversky, A. (1997). Money illusion. Quarterly Journal of Economics, 112(2), 341-374 · link
    The Ann-and-Barbara raise scenarios and the housing-sale scenarios demonstrating nominal thinking.
  2. Fisher, I. (1928). The Money Illusion. Adelphi
    Origin of the term and the first extended treatment of nominal thinking.
  3. Fehr, E., & Tyran, J.-R. (2001). Does money illusion matter?. American Economic Review, 91(5), 1239-1262
    Experimental evidence that money illusion slows price adjustment after nominal shocks.
  4. Bewley, T. F. (1999). Why Wages Don't Fall During a Recession. Harvard University Press
    Manager interviews showing resistance to nominal wage cuts and the morale account.
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