The tendency for people to think of money in nominal, rather than real terms.In economics, "nominal value" refers to any price expressed in money of the day, as opposed to "real value," which adjusts for the effect of inflation. The Money Illusion refers to the tendency of people to think of currency in nominal terms only. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is irrational because modern fiat currencies have no inherent value and their real value is derived from their ability to be exchanged for goods.
John Maynard Keynes coined the term "money illusion" in the early twentieth century, and in 1928, Irving Fisher wrote an important book on the subject, The Money Illusion. The existence of money illusion is disputed by monetary economists who contend that people act rationally (read: think in real prices) with regard to their personal wealth. Nonetheless, Shafir, Diamond and Tversky (1997) have provided compelling empirical evidence for the existence of this brain bias.
The Money Illusion influences economic behaviour in three main ways:
• Price stickiness: Money illusion provides one strong reason why nominal prices are slow to change even when inflation has caused real prices and costs to skyrocket.
• Contracts and laws are not indexed to inflation as frequently as one would expect.
• Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.
