Money illusion

Money illusion, coined by Irving Fisher in 1928, describes the human tendency to focus on the nominal dollar (or pound, or euro) value of money rather than its real purchasing power. The classic example: workers are more upset about a 2% nominal wage cut when inflation is 0% (losing 2% real purchasing power) than about a 0% nominal raise when inflation is 4% (also losing ~4% real purchasing power) — even though the second scenario is twice as bad in real terms. The nominal loss feels more salient because it is explicit.

Money illusion matters for inflation economics because it creates "downward nominal wage rigidity" — workers and firms resist nominal wage cuts even when real wages need to fall. This is part of why deflation is so economically destructive: in a deflationary environment, firms cannot cut nominal wages enough to clear labour markets, producing instead unemployment. It also explains why central banks target positive (2%) rather than zero inflation — a 2% inflation target provides a "grease" for real wage adjustments that a 0% target would deny.

In high-inflation environments, money illusion creates a different set of distortions. Workers may celebrate large nominal wage increases without checking whether those increases exceed inflation — and thus represent real gains. During the 2021–23 inflation surge, many workers in the US and UK received 5–6% nominal pay rises that felt generous but were actually real wage cuts of 2–3% because inflation was running at 8–9%. The perception gap — nominal gains viewed positively despite real losses — delayed the wage catch-up that came in 2024–25 as workers revised their expectations. The real wages term explains how to calculate whether a pay rise is a real gain or loss.

The existence of money illusion justifies several policy choices: (1) targeting positive inflation (around 2%) rather than zero, to preserve the real wage flexibility that nominal rigidities deny; (2) wage indexation in long-term contracts, which removes the illusion by automating the inflation adjustment; (3) clear, transparent inflation communication — central banks invest heavily in inflation literacy precisely because a public that understands real vs nominal distinctions makes better economic decisions. The foundational Shafir, Diamond, and Tversky (1997) paper in the Journal of Economic Perspectives provides extensive experimental evidence for money illusion across economic decisions.