The Money Illusion: Definition & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

After this lesson, you'll never look at money the same! In fact, after reading this lesson you may find that you, too, have fallen into this trap called the money illusion, but we'll figure out how to get around that.

The Money Illusion

Imagine you have two aunts. They were incredibly competitive when they were kids and nothing has really changed. They're both in their mid-40s and they continue to boast and quarrel about who has the better job, the higher income, the better spouse and so forth Aunt Phoebe lives in a developed country. She's an accountant and makes $50,000/yr. Aunt Monica lives in a developing country. She's also an accountant and is paid the equivalent of $45,000/yr (for this example we'll keep Aunt Monica's salary and expenses as their equivalent in USD). It's Christmastime and you hear the two blabbering away. Aunt Phoebe is boasting because she just received a 5% raise at work. 'Well, that's nothing,' replies Aunt Monica. She has just received a 15% raise. If you know that the developed country Aunt Phoebe lives in has an average yearly cost of living of $10,000 and the average inflation rate is 3%, and you know the developing country Aunt Monica lives in has an average yearly cost of living of $9,000 and averages 10% inflation, which aunt is really better off? Who has the right to boast?

In this lesson, we'll learn about an economic concept called the money illusion. This is a flawed tendency to think of currencies in nominal terms, instead of purchasing power. We'll define each of those terms - nominal and purchasing power. We'll give examples of each as we try to answer the question: which aunt has the right to gloat? We'll then give some real-world examples of the money illusion.

Background

The Money Illusion is a book written by economist Irving Fisher in 1928, who introduced the concept. Fisher starts out by giving a vivid example of this illusion. He describes a German woman shopkeeper during a time when Germany was undergoing massive depreciation of their currency (i.e. the German mark was losing its value) due to hyperinflation following World War I. The shopkeeper thought she was generating a profit because she sold shirts for more than they cost her to purchase them the year before. But, as Fisher describes, in terms of purchasing power she actually lost money. Purchasing power refers to the amount of goods or services she can buy with the currency. Nominal currency is money not adjusted for inflation. A real currency is adjusted to reflect inflation.

Let's put some numbers behind the German shopkeeper example. Let's say she bought the shirt in 1927 at 10 marks and sold it one year later in 1928. During that time, lets say inflation averaged 100%, and the cost of her daily living expenses increased in line with inflation. Let's assume her living expenses were 5 marks per day in 1927. She sells the shirt and pockets a 5 mark profit. If inflation had been 0% during that time, she could fund one day's worth of living expenses with the profit, but inflation has caused her daily living expenses to double from 5 marks to 10. Her 5 mark profit then can only fund a half day's worth of living expenses. Even though she has shown a nominal gain of 5 marks, she has diminished purchasing power.

Money Illusion in our Aunt Example

Now let's go through the same type of analysis with Aunt Phoebe and Aunt Monica. For Aunt Phoebe, her salary at the beginning of the year could cover $50,000 / $10,000 = 5 years of living expenses. After the 10% raise and 3% inflation, she can cover $50,000 X 1.10 / $10,000 X 1.03 = 5.34 years of living expenses, so the salary increase does represent an increase in purchasing power. At the beginning of the year, Aunt Monica's salary also covers 5 years of living expenses: $45,000 / $9,000 = 5 years. After the 15% raise and 10% inflation, she can cover $45,000 X 1.15 / $9,000 X 1.10 = 5.23 year of living expenses. Aunt Monica's purchasing power has increased, because her salary increase was greater than the cost of living increase, but she didn't have the purchasing power increase that her sister Phoebe did.

To recap the last two examples: on its own, the nominal salary gain doesn't mean much. You need to see whether the gain increases purchasing power.

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