Does Money Illusion Matter?

Abstract

Money illusion means that people behave differently when the same objective situation is represented in nominal or in real terms. To examine the behavioral impact of money illusion we studied the adjustment process of nominal prices after a fully anticipated negative nominal shock in an experimental setting with strategic complementarity. We show that seemingly innocuous differences in payoff presentation cause large behavioral differences. In particular, if the payoff information is presented to subjects in nominal terms, price stickiness and real effects are much more pronounced than when payoff information is presented in real terms. The driving force of differences in real outcomes is subjects' expectation of higher nominal inertia in the nominal payoff condition. Due to strategic complementarity, these expectations induce subjects to adjust rather slowly to the shock.

Nominal increases and the perception of likelihood

“…However, in contrast to Miller et al (1989), while the situations are statistically equivalent a priori, the actual probability of success may depend on others' choice in some scenarios. These findings on likelihood are similar to the findings on money illusion -a tendency to think in terms of nominal rather than real monetary values -by Fehr and Tyran (2001). Fehr and Tyran (2001) show that money illusion could be quite substantial and long lasting, not because of individual mistakes, but because some people behave differently in anticipation of money illusion by others.…”

“…These findings on likelihood are similar to the findings on money illusion -a tendency to think in terms of nominal rather than real monetary values -by Fehr and Tyran (2001). Fehr and Tyran (2001) show that money illusion could be quite substantial and long lasting, not because of individual mistakes, but because some people behave differently in anticipation of money illusion by others. These findings are also reminiscent of the findings by Shafir, Diamond, and Tversky (1997), who show that although most people can distinguish between nominal and real monetary values, they still tend to prefer a higher nominal value.…”

“…About equal number of students (10% of the total respectively) thought that having more or less points made it more likely for them to get the courses they wanted. 1 However, when asked about how upset they would feel in the case of failure, the fraction of students who chose college B -the college that gave more points -roughly doubles while the fraction who chose college A increases only slightly. This result is consistent with counterfactual thought (Miller et al, 1989): ex ante, more bid points in college B makes it easier to imagine success in bidding, leading to greater ex post disappointment when bidding fails.…”

Notes and Communications

“…On the one hand, several welldesigned psychological experiments at the individual level show a convincing bias towards nominal rather than real magnitudes, which according to these findings results in considerable inertia (see Shafir et al (1997);Fehr and Tyran (1997)). On the other hand, recent experience also appears to provide clear-cut evidence for the existence of money illusion at the individual and aggregate levels.…”

What Does Behavioral Economics Mean for Policy? Challenges to Savings and Health Policies in the Netherlands

“…Using a variety of empirical approaches, researchers have found strong indications of money illusion. Examples are Shafir et al (1997) using stated preference data, Fehr and Tyran (2001) using laboratory experiments, and Kooreman et al (2004) using a quasiexperimental approach. Kooreman et al (2004) found that after the introduction of the euro people donated more in real terms to a charity than they did before.…”