Economic Literacy and Money Illusion

An Experimental Perspective

Helena Chytilova

• Publisher: Routledge
• Year: 2017
• Topic: Business
• eBook ISBN:
  9781315304458
• Subtopic: Business General
• Index: Business

The concept of money illusion, a recently resurrected phenomenon of behavioral economics, is a real fact of economic life, the potential role of which should no longer be dismissed. Despite money illusion being utterly suppressed by mainstream economists, small deviations from rationality, together with trends in behavioral economics, alleviate the denial of money illusion induced by the rational expectations revolution. This book argues that money illusion seems to be a ubiquitous phenomenon, affecting various areas such as financial markets, housing markets, labor markets, consumption-saving decisions, and even development at the aggregate level induced by coordination issues. Furthermore, in light of the educational efforts of central banks and other institutions, it is worth considering whether solid economic training would provide guidance for the public regarding their decision-making and thereby alleviate the effects of money illusion. The emerging field of experimental economics provides a unique opportunity for us to verify the presence of money illusion. Specifically, attention is devoted to the experimental investigation of reduction in the direct and indirect effects of money illusion with respect to the level of economic literacy acquired through economic education.

Economic Literacy and Money Illusion will be of interest to the general audience and to those who are interested in behavioral economics, economics education, and experimental economics, as well as to policy makers and institutions. Last but not least, it will help develop students' interest in alternative economic theories.

NB. The research and writing of this book was made possible with the support of the University of Economics, Prague, Faculty of Economics, Department of Economics.

1Early theorizing about money illusion

Money is as money does, the dollar is what the dollar buys.

General F. A. Walker, economist (Fisher 1928, p. 18)

“Money illusion” as a concept is frequently referred to and, also, frequently rejected, where a ubiquitous belief in rationality dictates the trend of money illusion as being distant from standard economic thinking. In addition, many economists reacted with hesitation to explanations based on the simplistic concepts of money illusion, since it was in contradiction to the maximizing behavior of individuals and the equilibrium states of economies. In addition, irrational behavior inside a general equilibrium framework might appear to be rational outside that framework, considering the systemic coordination problems that subjects have to cope with.

The position of money illusion in economics is documented by Howitt (1987, pp. 518–519), who considers it as a more equivocal concept. Not only is the absence of money illusion the main presumption in the long run for neutrality of money, but, in contrast, money illusion was considered to be responsible in the short run for the non-neutrality of money such as in the case of Fisher’s explanation of business cycles.

The money illusion refers to the tendency of individuals to think more in nominal monetary values than in real ones. There are many definitions, differing slightly, used by authors. Leontief (1936) defines money illusion as a violation of the “homogeneity postulate.” According to him, demand and supply functions are homogeneous of degree zero in all nominal prices, where they depend on relative and not absolute prices. Patinkin (1965, p. 22), states that “An individual will be said to be suffering from such an illusion if his excess-demand functions for commodities do not depend solely on relative prices and real wealth.” Shafir, Diamond, and Tversky (1997, p. 348) interpret money illusion as “a bias in the assessment of the real value of economic transactions, induced by a nominal evaluation.” However, as Fehr and Tyran (2001) emphasize, the basic problem is how people perceive the veil of money, that is, whether they are able to recognize purely nominal changes that should not affect their decision.

There are many other recent studies, such as Brunnermeier and Julliard (2008), Vaona (2013), Cannon and Cipriani (2006), Agell and Lundborg (2003), and so on, showing that money illusion is still a topical issue that is receiving increased interest in contemporary research.

This chapter describes the early theorizing of economists about money illusion, its roots and origins. Attention will be devoted to Irving Fisher, who first coined the term “money illusion” and devoted his whole book to it. The second part deals with money illusion as contained in the works of John Maynard Keynes, which is scrutinized due to its rather implicit presence in Keynes’ work.

Irving Fisher’s Money Illusion

In 1928, Irving Fisher wrote a whole book entitled The Money Illusion, which was based on lectures given in the summer of 1927 at the Geneva School of International Studies. This book introduced the term “money illusion” to economic science, however, the term had already been coined in his article “Stabilizing the Dollar” in 1919. Fisher (1928, p. 4) defined money illusion in his book as a “failure to perceive that the dollar, or any other unit of money, expands or shrinks in value.” The Money Illusion was written in the 1920s, prior to the 1929 Crash, and the main point was primarily to highlight the existence of a money illusion linked to the human fallacy of thinking about the dollar as something fixed. The instability of buying power of all monetary units, including the dollar, is demonstrated on various illustrative examples based on the author’s empirical observation. This is followed by the identification of hidden causes, for example, inflation and deflation, generating this instability, with resulting harm, which is often attributed to other causes. Consequently, the author proposes various remedies, emphasizing specifically the role of the government and monetary authorities in weakening negative consequences of harm.

Fisher is widely believed to have coined the term money illusion, but the concept had already been mentioned in the theories of classical economists, although not explicitly. Ricardo (1811), cited by Hahn (1947), states that when new money is introduced, prosperity spreads like magic, since the judgment of market participants is overly optimistic. Prices rise faster than costs, creating illusory high profits and making a stimulus for the creation of new enterprises. This boosts prices even further. The illusion is discovered only later once prices rise and the boom spiral goes in the opposite direction.¹

As Fisher suggests, people simply take it for granted that a dollar is a dollar and that all money is stable, emphasizing that almost everyone is subject to money illusion with respect to his own currency. This topic attracted his attention because of the trend of increasing prices caused by World War I and the related value of the dollar, which was unstable in its buying power. On the contrary, followers of Fisher, such as Shafir et al. (1997), Modigliani and Cohn (1979), and Akerlof and Shiller (2009), do not assume complete deception by money illusion, but rather a consciousness of nominal values, as will be mentioned later.

Together with another economist (Professor Frederick W. Roman), Fisher studied price changes in Europe and talked with various individuals they met by chance during their travels in Germany in 1922, as well as with Americans—including his own dentist. He concluded that “all people assumed that their own respective moneys had not fallen in value, but that goods had risen” (Fisher 1928, p. 8), believing various other reasons, such as the blockade or the destruction wrought by the war, were the cause of the high cost of living, but denying that the change in the value of the dollar could be responsible.

A particularly famous example is Fisher’s discussion with a very intelligent German shopkeeper in Berlin, when the German mark had depreciated by more than 98 percent (the price level had risen by about fifty-fold, leaving the currency to be a fiftieth of its original value). She sold him a shirt, explaining further that she bought the shirt initially for less and thereby made a profit. Unfortunately, she was deceived by money illusion: she made no profit, since the dollar was not the same value as she had thought, but had fallen. She instead assumed that the marks paid by her for the shirt a year ago were the same marks that she received from Professor Fisher. She has not recognized the hidden cause, “inflation,” which had led to the rise in the volume of marks, instead finding many trivial reasons for the high prices. Since her accounts were in a fluctuating currency (instead of translating her accounts into dollars or units of commodities), it looked like a profit, which was only a nominal one and she instead suffered a loss in real terms.

This example may be well generalized by the statement of Lord D’Abernon, British Ambassador to Germany, who said: “Professor Fisher, you will find that very few Germans think of the mark as having fallen” (Fisher 1928, p. 5). Additionally, Fisher (1928) claims that after World War I, people in America were aware of the fall of the German mark, as opposed to very few Germans who knew about it. However, Americans were not different in terms of their inability to perceive the value of their own currency. They generally thought of the dollar as fixed, despite the fact its buying power was changing. Based on these empirical observations, Fisher concluded that people tend to perceive the value of other currencies as better than the value of their own currency.

The gold standard present that time in the United States intensified this notion even further. Actually, the dollar was fixed in terms of grains of gold, but it was not fixed in terms of goods and benefits it could buy. In the United States, pure gold was sold at about $20.67 an ounce, and had remained unchanged since 1837 when the dollar was fixed at 23.22 grains of pure gold. These two figures “mutually imply each other” (Fisher 1928, p. 15), with no evidence that gold is constant in its buying power. An ounce of gold would always buy $20.67, given by the fixation of the dollar at 23.22 grains of pure gold. As a result, it means that gold is constant in terms of gold but not in its buying power over other commodities. As gold fluctuated, the dollar fluctuated as well, keeping the ratio between those two unchanged and leading to the false notion that the dollar is stable in terms of its buying power.

In other words, Fisher (1928) claims that the dollar could be used accurately for measuring the weight of sugar, but not for measuring the value. This may be further illustrated with the help of an example that he provides:

Our fixed-weight dollar is a poor substitute for a really stable dollar as would be a fixed weight of copper, a fixed yardage of carpet, or a fixed number of eggs. If we were to define a dollar as a dozen eggs, thenceforth the price of eggs would necessarily and always be a dollar a dozen. Nevertheless, the supply and demand of eggs would keep on working. For instance, if the hens failed to lay, the price of eggs would not rise [in dollars] but the price of almost everything else would fall. One egg would buy more than before [because they are more rare]. Yet, because of the Money Illusion, we would not even suspect the hens of causing low prices and hard times.

(Fisher 1928, p. 17)

In other words, people affected by money illusion tend to confuse the fixed weight of the dollar with a fixed value. The dollar is a unit of weight, which is “masquerading as a stable unit of value, or buying power” (Fisher 1928, p. 16).

Perception of inflation and deflation from viewpoint of money illusion

Based on this fact, Fisher (1928) aims to answer why the currency fluctuates in its buying power and links it, consequently, to the concept of money illusion, responsible for the false perception of the public about the fixed value of the currency.

The concept of relative inflation and deflation is applied, that is, inflation and deflation relative to the volume of trade in a given period. Fisher (1928) argues that if the circulation of money and the circulation of goods, each of the same number of dollars in value, should keep going at the same rate year after year, there is no reason for deflation or inflation. In other words, the flow of money is adjusting the pace with respect to the growth or shrinkage of the business. However, if these two circulations do not develop at the same pace, then the situation is different. If for instance the circulation of money rises, despite the constant rate of circulation of goods, the price level has to rise necessarily. Inversely, if the circulation of goods rises, keeping the flow of money fixed, the price level will decline. To sum up, if the flow of money is rising relatively to the flow of goods, the price level will rise. If the flow of money is falling with respect to the flow of goods and services, the contrary will happen with the price level. The former case is named “relative inflation,” the latter “relative deflation.”

Fisher emphasizes that the real income is of crucial importance for every economy. Man’s real income is given by its buying power multiplied by the nominal number of dollars he gets. This real income per capita expands or contracts in proportion to the circulations, the flow of goods and services per capita, and the flow of money per capita. As a result, possible causes of general price level changes are expressed in per capita terms:

•Per capita increase of money circulated.

•Per capita decrease of money circulated.

•Per capita increase of goods circulated.

•Per capita decrease of goods circulated.

If we assume the flow of goods per capita to be unaltered, any change in the price level may be solely attributed to a change in the money flow. If, however, the flow of money per capita is the same, any change in the price level may be attributed only to a change in the flow of goods per capita. Change in the flow of money per capita is called absolute inflation and absolute deflation respectively, whereas the change in goods per capita is known as relative inflation and relative deflation.

The most important outcome of these considerations is that money illusion hides the money side of the market, as people consider wholly or chiefly the goods market. The thinking is that the change in price level is due to a scarcity or a superabundance of the individual goods in the market. As a result, they consider the relative inflation/deflation to play a role. However, according to the empirical observation of various economists (Professor Cassel of Sweden, Professor Keynes of England, and Professor Holbrook working in California) named by Fisher, including his own findings, the money stream is varying greatly, in contrast with the goods stream which is varying little. Based on that, it can be derived that people should instead put greater emphasis on absolute inflation; however, they suffer from money illusion.

This implies the necessity to distinguish between the individual movements of prices (caused by individual supply and demand) and the general movements of prices (caused by money demand and supply). Most people ascribe an important role to the supply and demand of a commodity, which will equalize the price of everything, and neglect the forces of money demand and supply in changing the price level. The result of this money illusion is direct and indirect harm to the economy.

The direct harm caused by the money illusion

It seems at first sight that if price movements are solely governed by the movements in the value of money (and not determined by the scarcity of goods), the harm is dubious. For instance, if prices double because people use twice as many dollars to buy things, the monetary yardstick changes, but the thing measured does not change. However, as Fisher (1928) argues, everybody’s income is not adjusted to the price changes and therefore the change in the monetary yardstick is serious. The monetary yardstick not only affects all sales as the universal monetary unit in exchange, but it is also applied in the case of long-term contracts.

Standard contracts to pay present dollars for future dollars and their outcome are affected by inflation and deflation, which either expands or shrinks the dollar value. As a result, the effects of the monetary yardstick are...

Table of contents

• Cover
• Half-Title
• series
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Introduction
• 1 Early theorizing about money illusion
• 2 Rejection of money illusion
• 3 Renewal of interest in money illusion
• 4 The money illusion and its applications
• 5 Economic literacy and money illusion
• 6 Economic literacy and money illusion: An experimental approach
• 7 Experimental results
• Index