Money is an illusion, Nature is real!

Have you ever heard the concept of Money Illusion and how it exactly works?
So, if not, here I’ll explain.

What is Money Illusion?

Money illusion refers to our tendency to misinterpret changes in the nominal value of money without considering inflation. We focus on the amount of money in our hands, rather than it’s purchasing power.

In essence, money illusion is… illusory. This is why many think you can never go wrong with property.

Think about how much businesses paid for instant worldwide communication back in the day, compared to how cheap internet access is today. Money illusion causes us to focus on the amount of money rather than it’s worth.

Money illusion is sometimes also referred to as price illusion

Polarized views of economists

Some Economists disagree on the psychological issue of money illusion. Some contest the hypothesis, claiming that since consumers constantly encounter price fluctuations when shopping, they naturally conceive of their money in real terms and account for inflation.

A lack of financial literacy and the price stickiness of many products and services, according to some economists, are only a couple of the reasons why consumers can fall into the trap of disregarding the growing cost of living.

Applications of money illusion to real-world practices

Money illusion is often cited as a reason why small levels of inflation — 1% to 2% per year — are actually desirable for an economy. Low inflation allows employers, for example, to modestly raise wages in nominal terms without actually paying more in real terms. As a result, many people who get pay raises believe that their wealth is increasing, regardless of the actual rate of inflation.

Notably, people’s perceptions of financial outcomes are colored by money illusion. Experiments have shown, for example, that people generally perceive a 2% pay cut in nominal income with no change in monetary value as unfair. However, they also perceive a 2% rise in nominal income, when inflation is running at 4%, as fair.

Ways to overcome money illusion

Focusing on real value: Always consider the purchasing power of your money rather than just the numbers. Factor in inflation when evaluating financial decisions and financial planning.

Using real rates: When analysing investments or loans, use real interest rates (adjusted for inflation) to assess their true value.

Regularly reviewing finances: Keep track of your financial situation and adjust your strategies as economic conditions and resources change. Regular reviews can help you adapt to inflationary periods.

Quick recap:

• Money illusion posits that people have a tendency to view their wealth and income in nominal dollar terms, rather than recognize their real value, adjusted for inflation.
• Economists cite factors such as a lack of financial education and the price stickiness seen in many goods and services as triggers of money illusion.
• Employers are sometimes said to take advantage of this, modestly lifting wages in nominal terms without actually paying more in real terms.

Remember, it’s not just about the numbers related to your money, it’s about the real value it holds in your life.