Nominal values might look taller than real values, but ultimately only real values matter. However, many times we do get carried away by the impressive size of nominal values. A nominal GDP growth of 8% with 3% inflation looks more impressive than a real GDP growth of only 5%, although in reality both are equal.
If we were to choose between the two, most of us would be biased towards the nominal value. Many economists believe that we fall into the trap of nominal values because of what is called “money illusion”.
Johnny: Now, I think, is the right time to break the ”money illusion”, once and forever. What do you say Jinny?
Jinny: The term “money illusion” was coined by John Maynard Keynes. Another economist Irvin Fisher made this term more popular by writing a book titled The Money Illusion in 1928. This illusion is so deeply rooted in our behaviour that it’s really tough to come out of it. Most of the times we fall prey to “money illusion” due to our failure to distinguish between the real and nominal values in our economic dealings.
For instance, the money in your hand may have a real and nominal value; likewise you may come across real and nominal GDP, interest rates, wages and many more things. The problem is that we easily forget about the difference between the nominal and real values. Now tell me, what’s the value of a Rs100 note lying in your wallet?
Johnny: That hardly needs any guessing. The value of a Rs100 note is written as Rs100 on the face of it.
Jinny: But the value written on the face is just its nominal value. That may not represent its real value. The real value of your currency note depends on its purchasing power, which may keep on changing. Inflation erodes the purchasing power of your note and hence its real value may decrease. The “money illusion” arises due to our failure to recognize the erosion of the real value of our money and our continued faith in its nominal value.
Illustration: Jayachandran / Mint
We continue to believe that the value of our money is fixed while the prices of goods and services are changing. It is just like believing that the earth is standing still while the sun and stars are moving. It is difficult to perceive the decrease in real value of money. When we are unable to buy the same quantity of goods with the same amount of money after five years, our first reaction is that there might be something wrong with the supply.
Less supply can be one of the reasons beacuse of which you are unable to the buy the same quantity of goods. But another less apparent reason could be that your money has lost its purchasing power over the period. The real value of your money might be moving down in its own independent orbit. In that case, you would get less quantity of goods even when the supply is constant. How so?
Even after five years, your Rs100 note continues to be a Rs100 note in nominal terms. But the crucial thing could be that after five years there are much more Rs100 notes chasing the same amount of goods and services.
In other words, inflation might be eroding the purchasing power of our money, without our being aware of it, which leads to a kind of “money illusion”.
Johnny: What kind of ”money illusion” can arise in respect of wages?
Jinny: “Money illusion” in respect of wages can arise due to our failure to distinguish between the real and nominal wages. Let’s talk about the nominal wage first. Your nominal wage is the figure that comes written on your paycheck—the money that you actually earn. So if your current salary is Rs100, then your current nominal wage is also Rs100.
The “money illusion” makes us happy if our current nominal wage is higher than the wage earned two years earlier even though there might not be any increase or worse, there might actually be a decline in real terms. We may not pause to think in terms of our real wage, which depends upon the purchasing power of the money earned by us.
So a 2% increase in nominal wages with 3% inflation may seem psychologically better than no increase in nominal wages without any inflation. But with higher inflation rate our earning in real terms has in fact come down. We may fail to realize this due to “money illusion”.
A higher figure on the paycheck is immediately visible whereas the effect of inflation takes its own time to reach us.
That’s why Keynes believed that a moderate inflation is in fact good for the economy because it enables producers to increase the nominal wages, without creating any burden of the increase in real terms. A 2% increase in nominal wages with 2% inflation is a no-loss-no gain proposition.
Johnny: Well, that’s true Jinny, the “money illusion” in moderate form keeps the wheels of economic engine psychologically lubricated.
What:“Money-illusion” is deeply rooted in our behavior.
Why: “Money illusion” arises due to our failure to recognize the difference between the nominal and real value of money.
Who: The term “money illusion” was coined by John Maynard Keynes and Irvin Fisher.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com