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The term money illusion was coined in the 1920s by Irving Fisher, who defined it as “the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value” (1928, p. 4). As a matter of fact, money illusion refers to individual or aggregate economic behavior that consists in failing to distinguish transactions in terms of either nominal or real monetary values. This odd tendency is a direct consequence of the fact that money as a measure of value or unit of account, such as the dollar or the euro, differs fundamentally from physical yardsticks such as miles, kilos, and ohms in that it is not an intrinsically fixed measure over time.
This failure of the public to recognize real and nominal monetary changes is primarily a psychological phenomenon. In economic theory, with its bias toward monetary neutrality, this often has been assumed away, so money illusion has been regarded with some suspicion because the basic assumption of its absence underlies the long-run neutrality property embraced by the quantity theory of money.
Authors such as Leontief (1936) and Haberler (1964) consider money illusion to be a violation of the homogeneity postulate of economic theory. This theory hypothesizes that the demand and supply functions are homogeneous of degree zero in all nominal prices; that is, that demand and supply depend on relative rather than absolute prices and thus are insensitive to relative price changes. Patinkin (1949, 1965) extended this to include monetary assets as cash balances. Consequently, Patinkin postulates the absence of money illusion on the basis of the zero-homogeneity property of net-demand functions in all money prices and the money value of initial holdings of assets. Operationally, this is equivalent to the assumption of rational behavior that predicts that a proportional change in all prices and monetary balances would leave money’s purchasing power unaffected. It is this property that offers a yardstick for the assessment of money illusion in practice.
The absence of money illusion is the main assumption underlying neoclassical economic theory that cherishes David Hume’s famous “money veil,” denoting that money is only useful to exchange for other things which are unlike money of direct significance for economic welfare because, following Pigou (1941, pp. 20–27), money does not comprise any of the essentials of real economic life. Nevertheless, recognition of money illusion has a long tradition among economic heterodox and monetary economists. With his 1928 monograph Money Illusion Irving Fisher devoted an entire book to this topic, attempting to discredit the absence of money illusion in the real world on the basis of historical and statistical evidence from all over the world. To him, money illusion was an important explanation for business cycle fluctuations.
Nowadays, interest in the empirical validity of the assumption of money illusion is no longer anathema to the economics profession, firstly because the absence of money illusion helps to account for price stickiness and less than perfect economic adjustment processes, and secondly, because a lot of empirical or quasi-empirical evidence seems to support the occurrence of money illusion. Two kinds of evidence dominate. On the one hand, several well-designed psychological experiments at the individual level show a convincing bias toward nominal rather than real magnitudes, which according to these experiments results in considerable inertia (see Shafir et al. 1997; Fehr and Tyran 1997). On the other hand, recent experience also seems to provide clear-cut evidence for the existence of money illusion at the individual and aggregate levels. The most notable evidence is associated with the introduction of the euro in 2002. This operation offered a splendid opportunity for a real-life experiment to examine the occurrence of money illusion in the main western European countries. From a purely monetary point of view, the replacement of the national currencies of the Euro zone countries by a single currency merely amounted to a redefinition of prices through multiplication by a given and fixed number, for example 0.45 for the Dutch guilder. According to the homogeneity postulate— that is, the absence of money illusion—demand and supply conditions remain unchanged. However, this purely nominal operation resulted in an upward pressure of prices for particular commodities and especially services, affecting household expenditure, as national account statistics of Euro zone countries unambiguously show. This statistical observation, combined with ad hoc information on expenditure in several sectors of the economy in the relevant countries, point to some degree of money illusion. So, both economic experiments (with questionnaires on hypothetical situations allowing either nominal or volume variations) and actually observed expenditure behavior seem to violate the neutrality property of money. Hence, the empirical evidence indicates the existence of money illusion. Moreover, the difficulty of distinguishing between real and nominal exchange rates in daily economic activity provides additional empirical support for this conclusion.
Taken together, the occurrence of money illusion is quite likely in the real world and is, in fact, nothing but a particular manifestation of incomplete knowledge or economic frictions. These findings discredit monetary neutrality of neoclassical economic theory and the innocence of a nominal monetary reform in purchasing power such as the introduction of the euro in 2002.
- Fehr, Ernst, and John-Robert T 1997. Does Money Illusion Matter? American Economic Review 112: 1239–1262.
- Fisher, Ir 1928. The Money Illusion. New York: Adelphi.
- Haberler, G 1964. Prosperity and Depression: A Theoretical Analysis of Cyclical Movements. 4th ed. Cambridge,
- MA: Harvard University Pr Note that the relevant footnote has disappeared in later editions.
- Leontief, Wassily. The Fundamental Assumptions of Mr. Keynes’ Monetary Theory of Unemployment. Quarterly Journal of Economics 51: 192–197.
- Patinkin, D 1949. The Indeterminacy of Absolute Prices in Classical Economic Theory. Econometrica 17: 1–27. Patinkin, Don. 1965. Money, Interest, and Prices. 2nd ed. New York: Harper and Row.
- Pigou, Arthur 1941.The Veil of Money. London: Macmillan.
- Shafir, Eldar, Peter Diamond, and Amos Tversky. Money Illusion. Quarterly Journal of Economics 112: 341–374.
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