ECON430-Topic #4: Money Illusion and the Phillips Curve

I would like you to consider the selected chapters from Akerlof & Shiller’s Animal Spirits, and Mishkin’s Monetary Policy Strategy chapter as they relates to the textbook model of what central banks do and how they do it. Do you believe there is enough evidence to show that there is money illusion or not? You might also consider whether or not you believe there is a long-run trade-off between inflation and unemployment. Most of the theories we have discussed assume that there is no long-run trade-off between inflation and unemployment. If there is or is not a long-run trade-off, how might we need to re-examine our economic models? Do we need a fundamental change in our thinking, or are Akerlof and Shiller overstating their case? Finally, you could consider the role that money illusion plays in the conduct of central bank policy. Does the Fed need to alter their conduct of policy if there is money illusion? Or should the Fed continue to act as they have going forward? Were recent events simply bad luck and a large shock to demand or productivity? Or does the Fed have some crucial role to play going forward?

This blog is largely open-ended, but I would like you to consider not just supporting your argument, but also defending your stance. You can discuss any of these issues as they relate to central banking and monetary theory. Try to imagine what someone who disagrees with you might say when you are formulating your comment. Also, offer some evidence to support your argument.

22 thoughts on “ECON430-Topic #4: Money Illusion and the Phillips Curve”

  1. I think money illusion does exist, but it is different for every individual. Some are experiencing it to a large extent, others to a small. This makes it difficult to aggregate individual’s preferences in a meaningful way, especially when considering policy. For example, a paper written by Akerlof (and Kranton) talks about individual and corporate identity, and how firms can pay some workers less for same performance if the identities coincide (1). This article takes a scientific perspective on money illusion, which the study found does exist (2). An article by A. Sen named Rational Fools also illustrates and important point, that we are often inconsistent in our preferences and actions and that our rationality is questionable. I think this evidence contradicts Friedman’s beliefs. But really, this stuff casts doubt on the effectiveness of Fed policies. There is a fallacy of composition at play, because if we cannot infer meaningful information about individual opinions and preferences, how can policy be created that will be effective on an aggregate level? I think the Fed is perhaps the wrong institution to try to target inflation and unemployment.

    (1) Identity and the Economics ofOrganizations by George Akerlof and Rachel Kranton
    (2) http://scienceblogs.com/cortex/2009/04/money_illusion.php

  2. Based on everything I have read, I believe there is a short run tradeoff between inflation and unemployment but this relationship disappears in the long run. The Fed can take advantage of this relationship by controlling expectations for inflation. If there is a sudden inflationary shock people will not be able to adjust their expectations quickly enough. They will not ask for a raise in salary so employers (who have seen their prices change and know about the inflation) feel like they are paying a lower real wage and can afford to hire more workers. This decreases unemployment and raised output in the short run. In the long run, people adjust their expectations to what they actually see in the economy and will ask for a raise in salary. This will force employers to layoff workers and unemployment rises and output falls to levels prior of the inflationary shock. Thus, it can be said that people suffer from money illusion in the short run and there exists a tradeoff between inflation and unemployment. However, in the long run people do not suffer from money illusion and money itself is neutral. We might need to re-examine our econometric models because the theory of rational expectations may not be realistic. Studies (*found below) have shown this short run tradeoff which means agents, on average, were not correct about their predictions so we may need a different rationale for modeling the economy

    *The Trade-Off between Inflation and Unemployment
    Frank Brechling
    The Journal of Political Economy, Vol. 76, No. 4, Part 2: Issues in Monetary Research, 1967 (Jul. – Aug., 1968), pp. 712-737
    Published by: The University of Chicago Press
    Stable URL: http://www.jstor.org/stable/1830371

  3. I believe money illusion does indeed exist in today’s society. In addition to the sources already presented in this blog, when you think about people you know, and observe their economical decisions, it becomes fairly evident that some degree of money illusion exists in the economy. With money illusion present in most economic transactions, the Fed must alter the way in which it conducts policy. From Mishkin’s chapter on transmission mechanism, it becomes obvious that expansionary monetary policy greatly influences nominal prices. Unfortunately, these changes in nominal terms may be counterproductive to what is really going on (real price changes). A paper by Jianjun Miao and Danyang Xie concluded that these misperceptions can distort people’s understanding of long-run growth and wealth.1 They further illustrated that the monetary authority (the Fed) must set a growth rate of the money supply so that it corrects for these misinterpretations. In other words, in order for the Fed to effectively change economic transactions to behave according to real prices, they must essentially alter expectations of nominal prices so they correlate with the actual real prices. This is very much like what much of our class has discussed: The Fed must trick people. So, the Fed should focus most of its efforts on creating beneficial misperceptions, instead of attempting to change people’s train of thought. It seems that no matter what, money illusion will always be an integral element of people’s judgment. I’ve at least enjoyed a wage increase without including inflation into my reasoning and I bet many others have as well.

    1.) “Monetary Policy and Economic Growth under Money Illusion.”
    http://people.bu.edu/miaoj/illusion.pdf

  4. I agree with Drazen in that money illusion does exist in some situations. In regards to the Phillips Curve, I believe people expect unemployment to increase as inflation decreases in the short-run. As low inflation occurs, “money illusion is going to make people perceive the labor market, and income growth, as worse than they actually are” (1). Even though money illusion may occur during this period, some believe it “can only last so long” (2). People may not expect their wages to reflect periods of high or low inflation, and therefore employers can change their wage as they wish. However, others may be in tune with this information and want their wage to reflect that of inflation. With both of these opinions in mind, would firms even be able to set wages to inflation on a regular basis? Or would these have to reflect expected inflationary targets?

    (1) http://www.theatlantic.com/business/archive/2010/04/how-will-the-economy-affect-mid-term-elections/38801/
    (2) http://www.valueexpectations.com/blogs/how-we-got-here-weak-dollar-and-how-it-caused-global-financial-crisis04202010

  5. It seems that in the short run people tend to ignore low inflation levels and prices, especially wages, are downward rigid, partly due to menu costs, and contract readjustment time frames. This premise indicates that people may confuse real and nominal changes in the price level. This misperception of the current state of the economy opens the channel for activist monetary policy to change output levels in the short run.
    This effect of inflation on output then leads us to believe there is a short run trade-off between inflation and unemployment. However, if inflation is high, then the trade-off disappears and the two variables become independent of each other. Overall, in the long run, the Phillips Curve should vertical, indicating that monetary policy has no role in determining output growth.
    Mishkin does a great job in detailing how the transmission mechanism of short term expansionary monetary policy affects output levels. His model assumes, of course, that there is a positive relationship between the growth of the money supply and growth of income, at least in the short run.
    An interesting point made by Akerlof et al. is that the crisis of 2008 had its foundations not only in “traditional” economic shock, such as an increase in demand for money, but also in what they, and many others call, a credit crunch. Meredith Whitney of the Wall Street Journal attributes the economic contraction to the lack of loans available to small entrepreneurs, who are potential drivers of the American economy[1]. To that I would add that the lack of credit undermines investment, and the Fed’s decision to pay interest on excess reserves has not made the small business owner’s life any easier, as their loans do not pay enough in interest to the banks to compensate the risk of lending. This shows that confidence in the loaning markets has not been restored, and that the credit crunch is far from over, and will remain so should the Fed not eliminate IOER as it did quantitative easing.
    [1]http://online.wsj.com/article/SB10001424052748704471504574445470989162030.html

  6. I agree with others who think that money illusion does most certainty exist. One thing that I find difficult to believe is the assumption, common to many economic models, is that people are always rational when making decisions. Most people would obviously agree these models are very simplistic and not applicable to complex conditions that exist in the real world. This article discusses how money illusion existed with the introduction of the Euro in 2002 among Europeans (1). Many people perceived that they were “poorer” with The Euro versus their original national currency. The reason for this was the perception was the belief that they were better off with their old country which had a high value exchange rate with one Euro. In other words, it’s not the real value of money that matters to people, it’s the quantity.

    I believe that money illusion is strongest in the short term. Using the example of the introduction of the Euro, once people thought of the Euro as their national currency, they would stop comparing it to their old national currencies.

    (1) http://knowledge.insead.edu/contents/wertenbroch.cfm

  7. There are a lot of controversies over the Long-Run Phillips Curve. Although the vast majority of economists agree upon the vertical LRPC, there are a number of theories that are designed to reject this point of view. For example, Tobin in response to Friedman’s “natural rate” theory proposed his own view of LRPC. Tobin argued that in real economy there were a lot of sectors (industries) and at any point in time there would be a different unemployment across industries, for instance one industry might be at full employment (b=1), the other one can experience some level of unemployment (b<1). Summing up all b's we get aggregate b<1. Given Tobin's equation for the PC:
    gw = [h(U) + (a – b)gY]/(1 – b), where the Long-Run trade-off between unemployment and inflation is expressed by dgw/dU = h'(U)/(1-b) < 0 where,
    gw = growth in nominal wages;
    U=unemployment rate;
    b=the speed of expectations adjustments;
    by plugging in b<1 we get negatively sloped LRPC. Unemployment according to Tobin could result from information asymmetry, productivity changes etc. Tobin argued that information asymmetry persisted even in the long-run, thus b<1 would always hold resulting in a negatively sloped LRPC. (http://homepage.newschool.edu/het/essays/keynes/inflation.htm)

  8. It seems that there is scientific evidence that may support the existence of money illusion. Without getting into the specifics of the study, some professors of economics and neurological studies, from the University of Bonn in Germany, worked together to test the existence of the money illusion while monitoring brain functions. Summarizing the results, when the participants were faced with a set of low wages and cheap goods and a set of high wages and expensive goods, the participants consistently chose the higher priced set and their monitored brain functions showed more pleasure from this basket, hence, more utility (1). Thinking of inflation on a microeconomic level supports the lack of a trade off between inflation and employment in the long run. Businesses make long term decisions that account for the changes in inflation overtime, such as in their capital asset pricing models or in accounting for salary and incentive packages, however, the effects of inflation do not have a direct effect on the employment of a business and thus the employment in the aggregate economy. The costs associated with hiring full-time employment involve recruiting and training and decisions to hire are long term in nature. Employee termination decisions can, also, be seen as long term in nature as the costs associated with rehiring at a later time are high and companies attempt to retain employees through prolonged periods of revenue declines. Because of this, the short term effects of inflation do not affect the long run hiring and firing of a firm.

    (1) http://www.pnas.org/content/106/13/5025.abstract

  9. I agree with the other posts on the blog, that there is some type of short term money illusion. When the Federal Reserve increases the money supply, prices rise, and firms will increase output and hire workers. The firms do not know 100% if the rise in prices is from increased demand for the good, or due to inflation. During this time however, if there is an increase in demand, firms will try and maximize profits, by increasing output. There is a significant lag time in the effect of increasing the money supply (1), and inflation may not be felt for months, or years. During this time, the Federal Reserve can increase output and lower unemployment. I feel monetary policy should be used without releasing the details to the public in order to keep up output. If inflation can be kept low, and monetary policy can stop or lighten a recession, it should be used. One reason to prevent a recession is the cost of having workers unemployed. They lose their skills when unemployed, which will hurt future long term output, I forget the economics word for this.
    (1) http://www.frbsf.org/publications/federalreserve/monetary/affect.html
    (2) http://research.stlouisfed.org/publications/review/00/03/0003sd.pdf

  10. There is a short-run trade off between inflation and unemployment; however there is little evidence to support this trade off in the long-run. Monetary policy influences unemployment temporarily and determines inflation in the long run. Moreover, the theoretical basis for this trade off is well understood. Price stickiness can easily explain why there is a short-run trade off between inflation and unemployment (1). Friedman explains: “If you try through monetary measures, to keep unemployment below this natural level, you are committed to a path of perpetual inflation at an ever-increasing rate. There is no other way in which you can keep unemployment indefinitely below this natural level (2).” He finally concludes that there is no long-run stable trade-off between inflation and unemployment. In the long run, expected inflation adjusts to changes in actual inflation. The Fed’s ability to create unexpected inflation exists only in the short run. Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate (3).

    1) http://147.162.174.79/personale/curri/castelnuovo/mankiw_2000_nber.pdf
    2) http://web.econ.unito.it/bagliano/macro3/friedman_jpe77.pdf
    3) http://econweb.tamu.edu/…/Inflation%20and%20Unemployment.pdf

  11. Money illusion, in my view is a real. H Money illusion is effects agents in both the long and short run and I believe it actually has a negative effect on the welfare of agents that are affected by it. Maio and Xie (2007) estimate that if you took two equal agents, one affected by money illusion, one unaffected, beginning in 1960, that their income difference would be 5% in 2007.

    I believe money illusion is natural because it is much easier for an agent to view money in nominal rather than real terms. I feel that one other reason it’s more natural is that inflation is not widely known. Regardless of efforts to prevent money illusion, I believe that it will most likely persist.

    In the Akerlof and Shiller readings, I think that the most convincing evidence for the existence of money illusion is the fact that we do not see more agents attempt to offset inflation using indexes. It seems to me to be the most practical way for firms, unions, etc to compensate for inflation when working out payment. Though, I think that speculation plays some role in the fact that indexes are not used often.

    http://people.bu.edu/miaoj/illusion.pdf

  12. According to Chapter 4 from Akerlof and Shiller, the old-time economists believed that there was some money illusion. Then the new age economists came about and said there is no way money illusion can exist. Economics became more scientific and assumed rational behavior in this new age. Akerlof and Shiller make a good point saying that why does it have to be one extreme or the other. One thing I have learned from this class is that there are many alternative views at looking at monetary theory. It seems to me that the best way is to look at all the views and see what they add to economic thought because they all have flaws.

    Money illusion probably exists at some point but it may just be people not caring. Say inflation was .5%. Is it worth going to your boss and demanding a .5% raise? What if you just started at the company or if the economy is in bad shape and you are worried about being laid off. Also, what if .5% is such a small amount you really don’t notice or care enough to ask for a raise. A different example is a standard of living adjustment given to employees. My mom receives one as an employee of Fairfax county public schools. The county did not pay out an adjustment this past year. She said many of the employees were mad about this. But in fact there was little to no inflation recently. So, why should the employees receive this benefit? Since, this was typical procedure it angered the employees but, if this was not part of their contract they would not of cared. I think if inflation is high enough people will ask for the raise or if it is just part of the norm they demand it. It really comes down to how the company runs things to see how it affects people.

  13. To me it seems as if there are both a long run and a short run affect from money illusion. From personal experience, I know that I mostly view prices in nominal terms, especially in the short run. Before I became interested in economics I never really paid attention to interest rates, and with out knowing the interest rate, there is know what to know wages and prices in real terms. I expect that most of the public is similar to me and only looks at the nominal wages and prices. Since we mostly look at nominal prices, then we are susceptible to working harder for less money. This could cause the long run Phillips Curve to be non-vertical, as well as the short run Phillips Curve. So I think Money Illusion should definitely be taken into consideration when creating monetary rule.

    Works Cited
    Akerlof, G. A., & Shiller, R. J. Animal Spirits. Princeton, New Jersey, USA: Princeton University Press.

  14. I believe money illusion exists. In the early 20th century the idea of money illusion was widely accepted (Akerlof). It was only with the down fall of the Phillips curve that economists questioned the idea of money illusion (Akerlof). Instead of just re-evaluating the existence of money illusion, economists rejected it for the idea of rational expectations. I believe rational expectations is completely over rated. First, in a study of Canadian wages, it was found that only 19% of contracts were indexed with inflation (Akerlof). This is evidence for money illusion. The most convincing evidence I saw was when Akerlof says, “Thus only 12% of economists, in contrast to 77% of the public say their greatest gripe with about inflation is that it makes the poorer (Akerlof).” This clearly shows money illusion!
    The main question is, Is there a long-run trade off between inflation and unemployment? I believe the answer is somewhat. When inflation is low, workers don’t demand a wage adjustment (Akerlof). However, they do demand a wage adjustment when inflation is high. (Akerlof). For this reason I believe the Phillip’s Curve can be adjusted to show a positive relation between inflation and output up until a certain level of inflation. At this peak level, enough people would become aware that the price increases were due to inflation and would stop working more. The fed should set out to find this level of maximum inflation they can maintain while people will still exhibit “money illusion.”

  15. In my view money illusion does exist to a certain degree. It is just in my view natural for people to take a more simplistic view at issues such as the value of their money. A majority of people do not factor in the effect of inflation upon the value of their money. In my research on the topic I found that a majority of studies including one by Ernst Fehr and Jean-Robert Tyran found that there are asymmetric effects caused by nominal shocks. A result that is derived from the fact that money illusion has caused people take nominal pay-offs as a proxy for figuring out real wages.

    However, I also am in the opinion that this is a beneficial thing for our economy. Money illusion I think aids the whole misperception of theory of inflation. With people not really taking into account inflation, they would perhaps look at raises in prices to be an indicator that they need to in fact work harder producing higher rates of outcome. Kind of along the lines of what Richard talks about, the whole money illusion effect might aid the fed in tricking the public with inflation rates through the simple fact that a large deal of the public may not even fully understand the effects of inflation. Rather, the public relies upon nominal shifts which can boost output.

    http://www.jstor.org/stable/2677924?seq=2

    http://www.jstor.org/stable/2978894

  16. Money illusion does certainly exist, which may be due to the lack of education (economic/financial) and price stickiness that is seen in goods. It also explains why nominal salaries do not fall which during inflation periods, real value of one’s salary actually drop. Money illusion may have also played a role in the housing crisis dealing with understanding the nominal and actual value of mortgage interest rates. Monthly nominal interest payments were quite low versus renting property so there was an increase in buyers because property prices seemed to be cheaper. At the same time, when inflation decreased, the real cost of mortgage payments in the future increased(1). Some may say that that money illusion can increase output but irrational behavior can do just the opposite. I do not believe that there is a long-run trade-off between inflation and unemployment due to the understanding that unemployment returns to the natural rate of unemployment. In the long run, returning back to the natural rate of unemployment will make cyclical unemployment zero as well as inflation equaling expected inflation.

    (1)http://veryevolved.com/2009/03/the-money-illusion/

  17. I believe there is money illusion to some extent. I will use a basic rationalization for this. A majority of people are uneducated on economic matters. By simply watching news coverage of political and economic stories, you can see money illusion at work. People complain about the rising cost of education, the rising cost of food, and many other factors.

    With this in mind, it makes logical sense that a high inflation will lead to an increase in output. As a result, this will lead to a decrease in unemployment as firms search for more labor to increase that output. However, in the long run, as wages increase, even with money illusion, employees will seek higher wages to offset the higher inflation. As this happens, unemployment will increase as wages increase, which will then decrease demand. Using this framework, there would only be a short term tradeoff between inflation and unemployment.

    Switching gears with that information, I tend to believe that the central bankers should seek to stabilize inflation in a manner that allows consumers and industries to proceed without a fear of its instability. While monetary policy can affect economic outcomes in the short term, the difficulties of long term repercussions and lag times make it inefficient at best. While the free market has many inefficiencies, so does government action. The market has basic supply and demand functions that cause it to be much more rational and representative of the true economy than any government action could be. Therefore, while the short run tradeoff would make monetary policy effective, it still may not be the most efficient method for long term economic growth.

  18. While the majority of economic models depend on people thinking in real terms, it is rare that people day to day even consider the effects of inflation in the short-run. However, in times of economic uncertainty people may pay much more attention to inflation. One European study followed the amounts of charitable donations by citizens of the Netherlands. The research found that in the pre-Euro days, charitable donations were very stable over the years even as inflation was steadily increasing. Once the Euro was introduced, initially, charitable donations seemed to fluctuate with the value of the Euro. As the Euro began to stabilize so did the charitable contributions. Though this study does provide evidence both for and against a money illusion. A unique theory could be postulated. Perhaps, money is only sometimes illusory. When the economy is very stable people become complacent at looking for real values and focus on nominal dollars (perhaps because there is no major economic changes and thus people do not look at the economy in general as much). In times of recession or monetary instability, people focus on their money and its place in the economy as a whole (they begin to focus on its real value). Economists need to rethink the use of models utilizing ‘real’ and ‘nominal’ values for rational individuals, not only how they are used, but when they each is appropriate.

    “Charity Donations and the Euro Introduction: Some Quasi-Experimental Evidence on Money Illusion” Peter Kooreman, Riemer P. Faber and Heleen M. J. Hofmans Journal of Money, Credit and Banking, Vol. 36

    “Money Illusion”. Eldar Shafir, Peter Diamond and Amos Tversky. Quarterly Journal of Economics, Vol 112.

  19. I think that money illusion does exist but varies according to the consumer so it makes it very difficult to gauge. I know from my personal experience that I before I took any advanced economics courses I was quite please with making a modest salary at my summer job, even though it remained the same for 3 years I said to myself “Well, it’s still good pay, at least he(my boss) isn’t paying me less.” When in fact he was, I never took inflation into account. I believed my wage had remained constant when it had actually decreased over time due to the relative increases in the prices of goods. It’s been argued that until fairly recently money illusion was discredited and that other factors were responsible for this nominal inertia so to speak. Things like staggering of contracts, informational frictions, and costs of price adjustments were thought to be the culprits (1) but I think these are just fancy economic terms used to describe a definite phenomenon. However, in order for this money illusion to be true, this would mean that there would have to be a negative relationship between inflation and unemployment, as the Phillips curve has suggested, which opposes some of the recent theories we have discussed. I think this is true because I believe that many workers use their nominal wages as references point, thus firms can keep their wages relatively low during periods of high inflation and therefore hire. In the long-run however, I believe that eventually the inflation will increase for too long or too dramatically, and the workers won’t continue to accept these wages, without asking for a raise for instance. In other words I don’t believe there is a relationship in the long-run, or at least, I’m not convinced quite yet. As far as money illusion and the Fed altering their policies, I think it could perhaps be beneficial for the Fed to make some adjustments. I think there is a definite conflict in the Fed’s expansionary policies in instances when real prices are conflicting with an increase in the money supply and nominal prices. The main issue is that the general public is not informed at least as far as money illusion is concerned, which was made very clear to us in the surveys we went over in Akerlof and Shiller’s paper. Having said this, I think it’s unfair to the general population not knowing what their wealth truly is and how it’s going to fair in the long run . I agree with what we have been going over in class that the Fed must commit to being irresponsible, change the publics’ expectations so they have a better idea of what the real prices are. (2) I do also agree with what’s been said, I think this should be one of the main goals the Fed should attempt to achieve, and perhaps they aren’t truly the best organization to be handling the issues of inflation and unemployment. However, I’d be interested in hearing some opinions of who else could take on this role effectively.

    (1) http://www.jstor.org/pss/2677924
    (2) http://online.wsj.com/article/SB10001424052748704471504574445470989162030.html

  20. I believe there is a significant amount of evidence to strongly suggest the reality of money illusion. Evidence suggests that the general populace does not recognize the effects of low levels of inflation. Specifically, they do not seem to comprehend price increases in relation to their wages and accordingly do not ask for price of living adjustments as long as the inflation involved is relatively small. This lack of understanding for real prices and income is well represented by the fact that a vast majority of individuals are strongly opposed to wage decreases, regardless of deflation and decreasing prices. The general populace views their wage in nominal terms, and does not seem to understand the real value of their income in relation to prices. “While individuals understand well that inflation increases the prices of goods they buy, they often overlook inflation effects that work through indirect channels (e.g.,general equilibrium effects). For example, Shiller (1997a) documents survey evidence that the public does not think that nominal wages and inflation comove over the long-run. Shiller (1997b) provides evidence that less than a third of the respondents in his survey study would have expected their nominal income to be higher if the U.S. had experienced higher inflation over the last five years.” (1) Stock prices and returns also seem to be generally misunderstood in nominal terms. A majority of individuals view a three percent return to their stock value as a gain without any regard to the rate of inflation, which might completely offset any perceived gains. This lack of understanding or responsiveness to low inflation and the misperception of real wages in nominal terms suggest that monetary policy can be effective to a certain extent in the short-run. This also suggests that there is a tradeoff between inflation and unemployment in the short-run, but only to a certain extent of low inflation. In the long run, there is no trade off between inflation and unemployment, meaning the Phillips curve is vertical.
    Akerlof and Shiller make a compelling argument against the current thinking of policy makers. The implications of money illusion suggest that rational expectations are not correct in reality, and Friedman’s assumption that all people have rational expectations is wrong. If a majority of the public makes decisions based off of nominal measures, how can the fed and economists hope to induce effective policies based off of incorrect assumptions. “Additional support for the economic significance of our findings comes from a postexperimental questionnaire based on Shafir et al. (2). We asked subjects to rate the economic advantageousness of a series of economic situations in which a person bought a house and sold it 1 year later. Similar to our experimental setup there was a high-price and a low-price version for each level of real change. For example, the house could be sold for 23% above buying price when inflation was 25% (high) or for 1% below when inflation was 1% (low), both implying a real loss of 2%. We constructed a measure of money illusion on the basis of whether subjects rated the first situation as more advantageous than the second. This measure was highly correlated suggesting that the amount of money illusion might affect economic evaluations in a systematic way. The findings in this paper suggest that money illusion is real in the sense that the level of reward-related brain activity in response to monetary prizes increases with nominal
    changes that have no consequence for subjects’ real purchasing power.” (2) Economic models based off of rational expectations that assume people view prices/wages in real terms need revision to incorporate the reality of money illusion and the individual’s bias towards a nominal understanding of values.

    (1)http://www.princeton.edu/~markus/research/papers/money_illusion_housing_frenzies.pdf

    (2)http://www.rnl.caltech.edu/publications/pdf/weber2009.pdf

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