Money Illusion – Is it making you delusional?

Our teacher taught this concept in class and I thought to myself that people are rational enough to figure this thing out and make a rational decision. But, to my surprise, about 85% people fell for the trick and ended up making wrong decisions.

Moneyillusion is a psychological matter, a notion that people appear to make systematic mistake in assessing money in nominal versus real terms. They feel that they think of their money, automatically, in real terms, based on the prices of things they see around them.

Let’s take an example. Imagine you work in a firm and as an employee you are offered three salary options:

#1- a raise of 6% in your salary, given 7% inflation

#2- a raise of 3% in your salary, given 2% inflation

#3- no raise in your salary, given 2% deflation

As a rational consumer (employee), please rank the three cases in terms of success of your salary transactions.

Most of us would choose the order:

#1>#2>#3

i.e., first case, 6% increase in salary being most favourable because it seems fair, and the third case, no increase in salary being the least favourable because it seems unfair. This order would be correct in nominal terms. But what is relevant is how well you did in real terms – adjusting for inflation/deflation. In real terms, the ranking is reversed – #3, with a 2% real gain, followed by #2, with a 1% real gain, followed by #1, with a 1% real loss. So, the order in real terms will be:

#3>#2>#1

Just because you too fell in the trap do not make you any less rational consumer (employee).

Hence, we conclude that the numerical/face value of money is mistaken for its real purchasing value. This is probably because the face value (nominal value) of money provides a convenient rule of thumb for determining value and real value is calculated if they seem highly crucial, like in periods of hyperinflation or in long term contracts.

The change in the real value over time is indicated by the change in the Consumer Price Index (CPI), which measures changes in the price level of the market basket of consumer goods and services. So, next time when you pitch your boss on a salary increase, keep an eye on CPI and don’t let money illusion do its tricks.

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