Ever heard your father fretting over the monthly income he earned can’t buy all the necessities at the end of the same month? Have you ever brooded over the snack, your mother bought you earlier and that you can’t get one, now?
Thinking of ‘what a rupee can fetch today and a decade before’, intends to surprise our intellects about the money’s worth. We have the tendency to ignore the present-day currency value to acquire goods and stick to the money’s value as it is. Behavioural economists call this delusion as Money Illusion. People are biased to conceive currency in terms of nominal value than in real terms. The real value of the currency implies the purchasing power of the goods that can be bought in general, especially relevant during inflation. This misconception is familiar to economists, but not to an ordinary person.
Dating back to the early 19th century, Irving Fisher, the celebrated American Economist pioneered neoclassical theories on Time Preference and Money Illusion. Neoclassicals, in contrast to the Classical, propagated their theories on the principle of rational thinking and non-neutrality of money. Irving Fisher in his theories incorporated personal factors: foresight and self-control that influences an individual’s impatience before entering the market. Back to Money Illusion, he began his research by surveying 24 residents of Berlin in 1922. In the aftermath of World War I, the German Mark had depreciated by 98 percent implying the 50 times price increase. Fisher, in one of the conservations with a woman shopkeeper, found that the woman not aware of inflation claimed to have attained a profit, as she purchased the good, cheap initially. He said that she was deceived by money illusion since, in reality, she made no profit as the german mark valued not same as before, but had fallen instead.
He devoted an entire book to Money Illusion, and published it in 1928. Fisher pointed out that people think their currency to be fixed while other real factors change. It suggests that the people are victims of money illusion. He elucidated that people were unwilling to adjust the nominal interest rates to changing price levels. Having spoken about foresight (rational thinking), self-control and cognitive illusion 100 years ago, Richard H. Thaler appreciated him as the Modern Behavioral Economist. Likewise, many economists viz., John Maynard Keynes, A.C.Pigou have illustrated the behavioural factors in their theories.
Psychology of Money Illusion
Researchers from the field of Cognitive Psychology have inferred that people respond differently when exposed to alternative representations of the same situation. Kahneman and Tversky (1979); Tversky and Kahneman (1991) discussed representations. For instance, suppose an individual is presented with a total wealth of $250,000 and a fair bet with a total wealth of either $240,000 or $265,000. In terms of gains and losses, the same choice is presented between a choice of $250,000 (status quo) and a square odd to gain $15,000 or to lose $10,000. Here, the same problem is framed in an alternative way which induces an individual to make different choices. In the former case of total assets, people prefer the risky prospect while in the latter, people prefer the status quo rather than the risky prospect. The individual decision is not strategic but based on the simplicity of options. Plausibly, it is the loss aversion that persuaded the individual to choose a different option in an alternative framing.
Perception of Money Illusion alike Block Illusion?
Multiple representations invoke biases which is a manifestation of the perception. This can be illustrated by considering three identical blocks placed in a row in either a two or three-dimensional phase. It is often perceived that the third block, farthest from the other two blocks is larger. This illusion is because we are prone to observe the blocks in a three-dimensional state naturally, which indeed make the farthest block larger. Block illusion is a remarkable piece of multiple representations as the people’s perception is a mixture of the object size in both two and three-dimensional states.
