Money Illusion
https://www.economicshelp.org/blog/glossary/money-illusion/
Money Illusion : Money illusion is the belief that money has a fixed value and the effects of inflation are ignored. Because of money illusion, during inflation, individuals may perceive an increase in nominal income as higher welfare – when this is actually an illusion and their real spending power has not changed because prices have risen at the same rate as wages.
money-illusion
For example, if workers receive a 5% pay rise, they may feel that this represents an increase in their living standards as their income is higher. However, if inflation is 7% then prices are rising faster than income, the effective purchasing power of a worker is falling (real wages -2%).
If workers receive a 1% pay cut, this is a psychological blow and workers may feel worse off. However, if prices are actually falling by 2%, then in effect, despite this nominal pay cut, their real income has increased by 1%. Despite the nominal wage cut, they can buy more goods and services than before. However, this may not be immediately apparent. At first glance, people may prefer a wage increase of 5% to a wage cut of 1%.
Origin of the term money illusion
The term was created by Irving Fisher who felt that a combination of rising prices and money illusion could seriously destabilise the economy. The concept of money illusion was popularised by John Maynard Keynes.
Maynard Keynes.
Reasons for money illusion
Price stickiness. Firms may resist changing prices according to costs because there is a psychological blow to raising prices. Consumers prefer stable prices and when prices rise, it can cause uncertainty and discourage consumption.
Failure to distinguish between nominal and real values. For example, if a government boasts about spending record levels of money on the health care system, it is not obvious that this might include inflationary effects and represent a smaller real increase. Another example might be the change in house prices. The nominal house price is more easily compared than the inflation-adjusted price.
monetarist-inflation-LRAS
Monetarist Phillips curve
Because of this money illusion an increase in the money supply can cause a short-term fall in unemployment
phillips-curve-monetarist-long-run
But, in the long-run, unemployment remains at the natural rate.
Rational expectations and no money illusion
Some economists dismiss the idea of money illusion. They argue that although individuals may be wrong some of the time. In aggregate they are correct on average over time. Thus, if there was an increase in the money supply, it is not the case that workers will be fooled into thinking nominal increases are real increases. Rational expectations suggest workers have a better knowledge of prices than some economists give credit. Rational expectations was promoted by John F. Muth (1961) and popularised by Robert Lucas.
Money illusion and printing money
https://m.youtube.com/watch?v=6JhJldLy6js&feature=emb_imp_woyt
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