The Money Illusion

What if I told you about an economic theory that assumed every person in the economy understood economic terms and kept up to date with the state of the economy? To be exact, what if I told you about a theory that assumed everyone in the economy based their decisions on the rate of inflation? You’d (rightly) say that was a daft and unrealistic assumption completely out of touch with how real people think. The reason for this is due to what is known as the Money Illusion.

If your wages go up by 5% but so does the price of everything in the country (aka inflation), then you really are no better off. This is well known to all economists but few ordinary people. Most people who be delighted they got a pay rise and go celebrate. This is really just an illusion (hence the name). Economists are aware of this and usually speak of changes in the real wage, that is the wage increase minus the inflation rate. So if your wages rise by 5% and inflation is 3%, then your real wage has risen by 2%.

The money illusion used to be a major economic concept until the 1970s when it was replaced after criticism from Milton Friedman. He argued that you can fool people once, but not all the time. He argued that people would catch on to the government’s scheme. So if inflation was 5% they would demand a wage rise of 5%. This would nullify any government action. Freidman argued that the result would only be spiralling inflation. While this theory dominated for decades, like most neo-classical theories, it is being criticised for being unrealistic and economists are returning to the money illusion.

Friedman’s theory assumes a lot. Honestly, how many non-economists know or even care about inflation? If you were to do a survey, how many people would be able to tell you what the inflation rate is? The only place the issues above are discussed is in an economics lecture, how is the vast majority of people who don’t have a degree in economics supposed to keep up? Does anyone in the world genuinely sit down with a calculator and compare their wages to the rate of inflation? They might in the event of hyper inflation or very high inflation, but this hasn’t been a problem in developed countries in decades.

There are numerous reasons why people may get fooled by the money illusion. The obvious reason is that most people don’t care about economics in the slightest bit and would be completely unaware of the rate of inflation. People won’t intuitively discover inflation rises by themselves because inflation is different for each person. Let me explain. The main driver of inflation in Ireland for the last decade or two has been house prices. However if you already own your house then this is meaningless to you. You are not going to ask your boss for a pay rise just because the guy down the street has to pay more for a house. Likewise if you don’t smoke, a rise in the price of cigarettes won’t affect you. Some people’s cost of living will rise far above the inflation rate while others will be far below. After all the official rate is only an average. Therefore people will put it down to personal choice. You shouldn’t look for a pay rise rather you shouldn’t buy a house/ stop smoking etc.

The worst part is that economists themselves cannot agree what the inflation rate actually is. Without going into too much technical detail, there are essentially two ways of calculating inflation. One takes a basket of goods and measures the price each year for the goods. However some economists argue that this over states the level of inflation because people do not always buy the same goods regardless of price, rather they’ll switch to cheaper ones if the price rises. Hence there are two rates of inflation, a high estimate and a low one (as well as versions that mix and match the two). If even economists aren’t sure what the inflation rate is, then what hope do ordinary people have?

This concept becomes important in the event of a recession. At the current moment in Ireland many people are calling for cuts in social welfare and on public servants wages. If both of these were cut by say 5%, it would cause huge problems for the government. There would be an outcry about the government penalising the poorest and most vulnerable members of society and the public sector would probably go on strike, crippling the country.

However, let’s say both social welfare and public sector wages were frozen but inflation was increased to 5%. This has the same effect of the first scenario except without the outcry or strikes. Government expenditure would decrease while taxes would rise. Sure there would be grumbling over the cost of living but this would be far smaller than in the first scenario.

There are further problems. Just because workers want a wage increase doesn’t mean they’ll get one. If the employer is stubborn, they’ll need a union to fight their cause. This mightn’t have been a problem when Freidman developed his theory at the height of union power, but since then unions have declined in most countries. At the moment hardly any private sector workers in America have a union. Even with a union there is still a good chance they’ll lose the strike. So even if workers can see through the money illusion they may not be any better off.

There is considerable evidence to believe the money illusion is true. Firstly very few contracts are negotiated with automatic wage increases linked to inflation. In fact in many areas this is unheard of. If workers really did see through the money illusion then surely this would be a major claim. The fact that this is not central to all contracts suggests workers may be deceived by the money illusion.  Studies find that prices too stay rigid (Animal Spirits by Akerlof and Shiller lists the important studies). People dislike price rises even if it is keeping up with inflation.

People don’t know everything. They don’t think like economists. It is absurd to assume that everyone in the economy knows the inflation rate and acts upon it. The simple fact is that most people are fooled by the money illusion.


Filed under Economics

3 responses to “The Money Illusion

  1. Once again, your words have reveal more and more of economics and I feel that I have a way to explain them to those in my life a little better. Thanks for the postings.

  2. As you hinted at, the rise of organised, powerful unions would likely see more workers ‘seeing’ through the money illusion. Until then I can’t see many in our society doing much about it though.

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