Money illusion is a problem. We need more than intuition to combat it.
Your dollar is likely not worth the same today as a year ago. The cognitive bias, money illusion, causes us to believe it is.
New Yorkers received a rude awakening in 2021: there were no more dollar slices of pizza in the city. Inflation had taken another victim.
Dollar slices define New York City street food culture. Like late-night Pakistani restaurants for cabbies and morning bacon, egg, and cheese on a hard roll for commuters, certain prices are expected to be eternally fixed. (Well, the latter surged in 2022 thanks to inflation as well.)
While there have been numerous theories about the cause of the 2022 inflation (and stagflation) surge, increasing prices on everyday objects took their toll—so much so that shrinkflation became a thing. Suddenly, our paychecks didn’t stretch as far.
Price fluctuations are a natural life cycle in any economy. Our reaction to these increases is in large part due to money illusion, a cognitive bias that causes us to think of money in nominal terms instead of real terms.
Since we paid a dollar for a slice last year, we expect that slice to be a dollar today. But that’s not how economies work.
Let’s break that down.
Losing to win
During Explore III, we presented the following question to Eco Trivia players.
Do you think the average person would rather experience a:
- 2% decrease in pay
- 2% increase in pay alongside 5% rise in inflation
While your gut might want those increased wages hitting your Eco account, that “extra” money will actually be worth less with high inflation. The temporary boost you feel quickly dwindles when you arrive at the grocery story or gas pump.
While it seems counterintuitive to choose a pay cut, your wages would actually go further provided there was no inflation.
Simply put, your dollar is likely not worth the same today as a year ago. Inflation makes this reality worse. Prepare to pay a dollar-fifty (or even two dollars) for that slice.
Here’s why: nominal dollar terms tell you the current price tag of goods and services without taking inflation into effect. Yet what matters to all of us are real dollar terms, which tell you the true value of goods and services because it strips out the effects of inflation. And even the most relatively stable currency in the world is volatile and subject to inflation.
Our brains just have to catch up to this fact.
Dispelling the illusion
The term money illusion was coined by economist and statistician Irving Fisher in his 1919 journal article, “Stabilizing the Dollar.” Shortly after, economist John Maynard Keynes popularized the concept. Fisher subsequently wrote a 1928 book, The Money Illusion, further exploring the topic.
Classical economists continue to debate the validity of money illusion. They believe people make real-time adjustments to costs while factoring in wages. This notion is contradicted by employers that raise wages in nominal terms without addressing the real terms of money—giving them the ability to hire more workers at reduced real-term rates.
Debated or not, research bears out this illusion’s potency.
A 1997 journal article by Eldar Shafir, Peter Diamond, and Amos Tversky proposed that people do in fact consider nominal and real terms, but they have a bias toward nominal terms. Because of this, money illusion has the capability of affecting worker morale. If they see their nominal wages being stretched thin due to real dollar terms for goods and services, suddenly the reality of their wages hits home.
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.
Further, money illusion isn’t tethered only to inflation. Selling shares of stock or real estate at a nominal loss, which would benefit the person in the long run, becomes a psychological barrier due to money illusion. They might hold onto cratering stocks far longer than they would if they were thinking rationally. Likewise, nominal wage cuts (as we discussed during Eco Trivia) are seen as a short-term risk when, in fact, they could be a long-term boon.
Overcoming money illusion requires continued diligence to both wages and real-world costs. Developing a heuristic around price—like the beloved dollar slice—might appeal to intuition, and even a romanticized moment in the past, but to make your money work for you, a deeper investment in real monetary terms is required.