Chris DiRubba, Jhonn Lopez, Kylie Lynch, and Adam Reiter

Overview

Money illusion, a phenomenon where individuals misinterpret nominal changes in their wealth or income without considering inflation, has long intrigued economists, scholars, and policymakers alike. This cognitive bias can significantly impact individuals’ perceptions of their well-being and economic security, especially during periods of high inflation. Inflation is the rise in the general price level of goods and services over time and during times of high inflation, the gap between nominal income or wealth and its real purchasing power widens, potentially leading to a mismatch between perceived and actual economic conditions. For example, if someone receives a 5% raise in their salary but inflation is 7%, they might think they are better off when in fact their purchasing power has decreased. The intricate relationship between money illusion, inflation, and perceived well-being involves many factors, is fundamental for the future of our economy, and is crucial for the sake of well-informed financial decisions. This chapter is split up into eight sections, the first being the intro, the second dives into perceptions of well-being during periods of high inflation, the third talks about the psychology of money illusion; the fourth talks about the cultural and societal impact of money illusion; the fifth talks about the implications of widespread money illusion during inflationary periods in society; the sixth talks about the impact of inflation on perceived well-being and behaviors; the seventh talks about how to combat money illusion along with perceived well-being; and lastly, the eighth concludes.

Why is it Important to Study Perceptions of Well-being During Periods of High Inflation?

Studying perceptions of well-being during periods of high inflation is important for understanding the impact of economic conditions on individuals and societies. Inflation can significantly alter people’s perceptions of their financial security, future prospects, and overall quality of life. A real-life example exploring perceptions of inflation is from Milton Friedman, who noted that “The Phillips curve might shift and become vertical at the natural rate of unemployment. This phenomenon would occur when workers and firms accounted for long-term inflation, as increasing the costs of workers’ wages might decrease firms’ profits and stall employment.” (Li et al., 2016, p. 5341). In this scenario, as workers demand higher wages to keep up with inflation, firms may respond by reducing employment to maintain their profits. If people anticipate higher inflation in the future, they may demand higher wages to maintain their standard of living. However, if firms anticipate these higher wage demands and adjust their hiring practices accordingly, it could lead to a situation where higher inflation rates do not necessarily result in lower unemployment. Exploring the importance of studying these perceptions and gaining insight into how they shape economic behavior, social dynamics, and policy responses will shed light on the complex interplay between economic conditions and human well-being.

There are multiple different approaches that researchers take in order to study perceptions of welfare. To study the impact of government social benefit expenditures on stagflation indicators, researchers employed an autoregressive distributed lag (ARDL) bounds testing approach to cointegration (McDonald, 2009). This approach is a method used in econometrics to analyze the long-run relationship between variables. It involves estimating an autoregressive model that includes lagged values of the dependent variable and lagged values of the independent variables (De Vita et al., 2004). Researchers use this approach to test for the existence of a long-run relationship between the variables of interest. This is done by imposing certain restrictions on the coefficients in the model and then using statistical tests to determine whether these restrictions are valid. This method offers flexibility in handling regressors with different integration properties and allows for the investigation of both long- and short-term relationships between variables. To fully grasp the ARDL bounds testing approach, it’s important to have an understanding of several key concepts that are foundational to its methodology. Random walks, for instance, describe a model in which future values of a variable are based on its current value and random noise, often used to model unpredictable changes in variables like stock prices or exchange rates (Balsara et al., 2007). Error correction models are crucial for analyzing the long-run relationship between variables, incorporating both short-term dynamics and long-term equilibrium. They are especially useful for non-stationary variables, correcting deviations from equilibrium. Autoregressive Integrated Moving Average (ARIMA) models are powerful tools for time series analysis, particularly in identifying trends and seasonality. The integrated aspect of ARIMA involves differencing the data to achieve stationarity, a common requirement for applying the model. The ARDL bounds testing approach, while robust, has limitations. It assumes linear relationships, possibly oversimplifying complex economic dynamics. This method may miss nonlinearities or structural breaks and requires subjective lag length selection. It might not suit variables with differing integration orders, leading to biased estimates. Another study used a survey-based descriptive research method to investigate the potential for money illusion in Indonesia after a redenomination policy (Prabawani, 2018). This method was effective because it allowed for data collection directly from a large, representative sample. Surveys are practical for gathering information on people’s perceptions and behaviors, and crucial for studying phenomena like money illusion. Statistical tests like Cramer’s V-test and effect size calculations enhance the analysis, identifying differences and relationships between variables. Cramer’s V test is a measure of association between two categorical variables. It is based on Pearson’s chi-squared statistic and is used to determine the strength of association between two variables in a contingency table (Wu et al., 2013). Cramer’s V ranges from zero to one, where zero indicates no association and one indicates a perfect association between the variables. It is particularly useful when analyzing the relationship between two nominal variables. This method provides valuable insights into the public’s understanding and behavior in response to economic changes. Possible limitations of survey-based research are that they may include potential biases from self-reported data and low response rates. They may also struggle to capture complex data that other methods thrive at. Overall, interpretation of each method is key, and results should be complemented with other evidence and economic theory.

Historical examples of high inflation help economists today gain insight into its impact and extract valuable lessons from these experiences. High inflation time periods, such as the 1970s oil crisis and the 2007 U.S. subprime mortgage crisis, severely affected the welfare of US citizens, as many were uneasy and uncomfortable in this economic malaise (Li et al., 2016). Policies created to combat this high inflation created more unease, such as expansive monetary policy. This policy is often used to stimulate economic growth by making borrowing cheaper and encouraging spending and investment. While lower interest rates can stimulate demand and potentially reduce unemployment, they can also fuel inflation, especially if the economy is already experiencing supply-side constraints. In a stagflationary environment, such as the 1970s oil crisis, expansive monetary policy may not be as effective in stimulating real economic activity while risking further inflationary pressures. “If that expansive monetary policy was ineffective, stagflation would recur and people would fall into another economic malaise. Thus, there is still a risk of stagflation that should not be ignored.” (Li et al., 2016, p. 5340). High inflation erodes the purchasing power of individuals’ incomes, leading to a decrease in real wages and a higher cost of living. This reduces the standard of living for many people, especially those on fixed incomes or with limited resources. The oil crisis serves as a poignant reminder of the far-reaching impacts of energy price shocks on economies and societies. By learning from the lessons of the past, policymakers can better prepare for and mitigate the impacts of future crises and help maintain perceptions of well-being.

In order to gain a deeper understanding of the concepts of money illusion and well-being during periods of high inflation, researchers have conducted studies in various countries, including Indonesia. Indonesia is particularly relevant for studying this behavior as it is a post-redenomination country where there is a tendency among the public to focus more on the nominal value listed on the currency than the real value (Prabawani, 2018). Factors such as cultural and social norms, education and awareness levels, income distribution, social welfare systems, and historical and political contexts all played a role in Indonesia’s struggle with money illusion. Similarly, what is predicted to happen in Indonesia echoes experiences in Ghana, where the phenomenon of money illusion is driven by the perception that the price of goods and services seems cheaper after redenomination (Prabawani, 2018). This will be discussed in depth later in this chapter. This perception can lead to hyperinflation, as individuals may incorrectly assess the real value of their money. However, monetary policies can be implemented to correct these deviations in decisions to consume or save among those experiencing money illusions. While money illusion may be a common phenomenon during periods of high inflation and redenomination, appropriate policy responses can help mitigate its effects on individuals’ consumption and saving behaviors.

During the global economic crisis from 2007 to 2008, the financial sector’s actions, including the widespread unawareness of the money illusion, led to significant public borrowing at negative real interest rates. In light of the surprising behaviors observed during the global financial crisis, understanding individuals’ perceptions of well-being during periods of high inflation is crucial for comprehending the complex interplay between economic factors and human decision-making. This proves the importance of studying perceptions of well-being, as individuals and institutions may make decisions that seem rational in the short term but have detrimental long-term effects. Understanding these behaviors can inform policies and regulations to mitigate the impact of economic crises and improve overall well-being. One of the most significant insights from the crisis came from Alan Greenspan, who expressed shock at the behavior of financial firms, stating, “’Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief’” (McDonald, 2009, p. 249). This quote underscores the surprising behaviors of financial firms during the crisis, challenging the assumption of rational self-interest in economic models.

One of the most effective ways to understand the complex effects of economic conditions on people and communities is to look at how people feel about their well-being when inflation is high. Inflation can profoundly influence people’s perceptions of financial security, future prospects, and overall quality of life. By examining these perceptions, one may gain a deeper understanding of how economic conditions shape human behavior, social dynamics, and policy responses. Drawing from historical examples such as the 1970s oil crisis and the 2007 U.S. subprime mortgage crisis, we see how high inflation can erode purchasing power, reduce real wages, and lower the standard of living for many individuals. Lessons from these crises can help create more effective policy responses and address the need to anticipate and mitigate the impacts of future economic challenges. Furthermore, empirical studies, such as those conducted in Indonesia and Ghana, illustrate how cultural, social, and economic factors contribute to the phenomenon of money illusion during periods of high inflation. In light of the surprising behaviors observed during the global financial crisis, including the widespread unawareness of money illusions, it is evident that studying perceptions of well-being is essential for understanding the complex interplay between economic factors and human decision-making. These insights can inform policies and regulations to mitigate the impact of economic crises and improve overall well-being, emphasizing the significance of continued research in this field.

Psychology of Money Illusion

The psychology of money illusion provides insight into how individuals perceive and react to changes in their economic environment, particularly in terms of nominal versus real representations of wealth. “While economic information is presented to us in monetary terms (money prices, money income and wealth in monetary units), some of us cannot see through the veil, and consequently, they make decisions against their own best interests: they disregard the changes in the price level, thus they confuse nominal and real prices.” (Vincze, 2019, p. 192). In this quote, the author argues that while money illusion is often seen as a cognitive bias to be overcome, it may be inherent to human decision-making, akin to how we perceive optical illusions due to the limitations of our senses. This confusion can have negative consequences, which is why it is important to study how people perceive economic information, especially during periods of high inflation. He suggests that trying to completely eliminate the illusion of money may not be fruitful, as it is deeply ingrained in the way we represent and understand wealth.

Neuroscience offers a unique perspective on the connection between psychology and economics, providing insights into how the brain processes and responds to monetary incentives. There was a study done that investigated the effect of using different modes of presenting monetary rewards on behavior and brain activations (Miyapuram et al., 2009). In this study, participants were presented with large amounts of money but informed they would only receive a specific percentage of it. The results indicated differential responses within the orbitofrontal cortex (OFC), with more lateral areas encoding money illusions and relatively more medial areas encoding visual saliency. Interestingly, the ventromedial portion of the prefrontal cortex, which includes the medial OFC and anterior cingulate, showed responses to both money illusion and visual saliency (Miyapuram et al., 2009). These findings suggest that money illusion-related responses can be observed in reward-related brain regions, providing insights into the neural mechanisms underlying decision-making processes related to monetary rewards. This research not only contributes to our understanding of decision-making processes related to money but also highlights the complex neural mechanisms underlying economic behavior.

In economic decision-making, individuals often rely on different representations, such as nominal and real, to evaluate their options. A nominal representation focuses on the monetary value, such as giving 1000 euros now and getting back 1050 euros in a year (Vincze, 2019). In contrast, a real representation considers purchasing power, such as “giving 1000 2017 euros and getting back 1040 2017 euros based on expected inflation.” (Vincze, 2019, p. 198). Additionally, there’s an implicit real representation, which is harder to describe but involves neural networks associating signals about prices and inflation to gauge the real value of money. This dual nature of representations in the cognitive process highlights the complexity of human decision-making, especially in the context of money illusions. These cognitive biases contribute to money illusion in the form of indexation. According to Vincze (2019), studies done using questionnaires in Turkey and the US proved four things, “First, it was shown that many, though not all, people can understand the advantages of indexation. Second, money illusion manifests itself very clearly when justifying nominal contracting, people say: ‘I want to know how much money I will be getting’… Third, the future uncertainty of the price level is not appreciated in general. Fourth, many respondents believed that public price indices did not reflect their personal price indices.” (p. 203). The questionnaire proves that understanding these nuances can lead to valuable insights for economic policy and research, offering a more nuanced view of human behavior in economic contexts.

The psychology of money illusion offers a fascinating glimpse into how human cognition can shape economic behavior. From studies focusing on neuroscience to cognitive biases affecting human response, there is no doubt that money illusion is present in society. It reveals that individuals often perceive changes in their financial circumstances through a lens that prioritizes nominal values over real economic factors. This cognitive bias can lead to decisions that are not aligned with economic reality, impacting everything from personal finance to broader economic trends. Recognizing and addressing money illusion is crucial for promoting financial literacy and improving decision-making, setting the stage for a deeper exploration of its cultural and societal implications.

Cultural and Societal Impact

University students in Turkey were surveyed on money illusion and financial literacy by Celiktas and Yilmaz (2020). Part of this survey included a self-reported section where students input their perceived financial literacy. Financial literacy is defined as the knowledge of key personal finance concepts that can impact well-being. The more financial literacy a person has is associated with a higher level of knowledge on the money illusion. In essence, a stronger grasp of financial concepts can help individuals overcome the phenomenon of the money illusion allowing them to make informed financial decisions. They also found that those who self-reported a higher level of financial literacy actually had a lower level of financial literacy, implying overconfidence with those surveyed. These results are in line with the Dunning-Kruger effect whereas less-competent individuals’ overestimate their own abilities (Kruger and Dunning, 1999). The takeaway from this is that people are less impacted by money illusion if they know more about finance. This tells us the importance of financial education. Those who make more informed decisions regarding the money illusion will be more educated financially. If inflation is at 3%, someone not financially literate may be content with a 3% raise, discounting the fact that this is a 0% real raise. By contrast, someone with a higher literacy level would argue for a higher than 3% raise, ensuring that they get a real raise, not solely a cost-of-living-adjustment. A person with a lower literacy may harp on food and energy prices more because they are in the market for those items at a higher frequency than consumer durables. It is important to note that food and energy prices are more volatile as they are more inelastic, therefore the price may easily rise faster.

Teupe (2020) looks at how governments can finance war while comparing the methodology of John Keynes financing route. Keynes suggested compulsory savings in which the public would forgo parts of their income in favor of the state’s consumption in his How to Pay for the War (Keynes, 1939; Teupe, 2020). During wartime Keynes believed that the public could put a portion of their income towards the government. This would be a “forced loan” that the British government would supposedly pay off at the end of a war. The goal of this was to manage public debt by reallocating resources (Keynes, 1939). This was an alternative viewpoint to finance a war rather than taxation or borrowing. The framing of this looks at the nominal values in economic decision making. This directly relates to the money illusion as  policymakers would have a primary focus on the nominal values, negating the effects of future purchasing power. Policy makers may either be unaware or have the contemporary issues prioritized rather than the future. This may be to maintain a high public image without raising taxes or debt accumulation. Either way, this can distort perceptions of the true borrowing cost and economic decision making which can negatively affect economic models.

Teupe (2020) discussed the idea of “financial repression” (i.e. debt erosion) to finance war. Essentially, debt erosion is when the real value of government debt is decreased via inflation. This “financial repression” allows the government to owe a lower real value to the respective lender. As stated previously, policy makers may either be ignorant towards the money illusion, or have a lower priority of maintaining inflationary measures. The widespread ignorance of the money illusion facilitated public borrowing at negative real interest rates. This may have several societal implications such as misplaced trust in government policies, and contorted perceptions of economic well-being. These extremely low real interest rates would hurt people on fixed incomes as their purchasing power would decline. With the low opportunity cost of keeping dollar denominated assets, more people would make riskier investments (Hong and Sraer, 2013). Riskier investments may lead to a bubble or further financial instability. The rationale for these hazardous investments is due to investors chasing higher returns. Li and Sinha (2023) show that a rise of wealth inequalities are a product of inflation in which asset owners are better off than non-asset owners. For example, home owners during inflation, all else constant, would maintain the real value of their home whereas renters would lose the real value of their dollar denominated assets. Additionally, house wealth makes up about half of household net worth (Iacoviello, 2011). Teupe (2020) finds existing policies prior to the debt erosion, which would still be in place unless amended, may not benefit the public in the long run as they would not be tailored to debt erosionary expectations.

Implications of Widespread Money Illusion During Inflationary Periods in Society

Suffering from high inflation and a loss of confidence in their currency, Ghana had a currency redenomination in 2007 (Dzokoto et al. 2010). They did this by removing four zeros from their currency notes, 10000 old cedis = 1 New Ghana Cedi, and two zeros from their coins — 5000 old cedis = 50p. The purchasing power was the same in smaller denominations of money. An unintentional impact to the economy was a change in spending behavior.  Due to the perceived change in the denominations, the majority of the Ghanaian population suffered from the money illusion. This was through a temporary shock in perceived self-worth. People had the initial notion that they were worth less due to the lower balance in their bank accounts. This led them to spend more money post-redenomination. Inflation was approximately 10.7% pre-redenomination compared to approximately 20% post-redenomination. This increase in spending, and an increase in inflation, show that the goal of redenomination was not met.

Germany was undergoing hyperinflation in the early 1920s. Braggion et al. (2023) investigated the money illusion using the German stock market in this time period. The two hypotheses, they write, are the hedging hypothesis and the money illusion hypothesis in the stock market. Under the hedging hypothesis, “investors are more likely to buy and less likely to sell stocks when expected inflation increases,” whereas the money illusion hypothesis says, “investors are less likely to buy and more likely to sell stocks in periods of higher expected inflation.” The rationale behind convention, the hedging hypothesis, is to buy assets at a lower value and to sell them at a higher value, earning a higher profit. Braggion et al. (2023) find that individuals buy less stock during higher inflation. This idea is in line with the money illusion.

We can see the money illusion present when we see investors making suboptimal investment decisions because of their lack of understanding of the effects of inflation on their investments (Braggion et al., 2023). This is irrational stock market dynamics contributing to market inefficiencies and volatilities. Arguably, these inefficiencies can be mitigated through education, thus leading to a more sustainable market. The irrational market decisions  are more likely to lead to money illusion rather than a loss of faith in the economy. This is based on the finding that alternate investing options were seldom available, meaning the investors most likely liquidated their securities. Trading in foreign currencies was restricted during this sample period, making it an unlikely alternative. In addition to this, the authors find that investors did not significantly shift their funds to alternative investments to hedge against inflation (Braggion et al., 2023). Because there was a lack of alternative investing, meaning that the opportunity cost was primarily liquidation, the investment decisions were irrational for the inflationary time period.

Vaona (2011) investigates how the long run Phillips Curve under the money illusion is influenced by households’ and firms’ perceptions of real economic variables. There are a few general groups: households underperceiving real values, households overperceiving real values, firms underperceiving the real values, and firms overperceiving real values. Households who underperceive the phenomenon reduce their labor supply and time discount lending, whereas households over perceiving increases their labor supply and time discount lending. Households under-perception of real variables cause negative money non-superneutralities to intensify. Superneutrality is a concept that dictates the money supply has no effect on real variables in the long run. Under this assumption, if the money supply doubled, prices would double, with no real effect. Non-superneutrality is a concept that dictates that changes in the money supply does have real effects on the economy in the long run. This implies that with money supply changes, output, employment, and other real outputs would change. This highlights how there can be nuanced implications of the money illusion on economic models.

Superneutralities and non-superneutralites relate to the money illusion because it suggests that people correlate changes in nominal variables without considering changes in real variables. In the long-run Phillips Curve for firms, under-perception weakens negative money non-superneutralities, and over-perception does the opposite. Households and firms influence each other via perceptions in their decisions. This can be seen if a household seeks a wage based on misinformed perceptions, which would impact the hours set by firms. Output levels would be affected by the interaction between households and firms in the production process. Additionally, this sways overall consumption, given a different net output (Vaona, 2011). Imagine a town where households and firms were experiencing the money illusion. Households had a variance of what they thought prices should be. Economic ripples may come out of this distorted view—some firms hurt by the misjudged cost while others profited on the perceived gains. This has the potential to shape long-term economic outcomes, thus the importance of accurate perceptions in decision-making.

Impact of Inflation on Perceived Well-being and Behaviors

Inflation has consequences that aren’t limited to just the economy. While its effects on purchasing power and the erosion of real income are well-documented, inflation can also profoundly influence individuals’ perceptions of their well-being and alter behaviors, ultimately affecting the economy. As inflation occurs, people often will fail to adjust their perspectives accordingly. This leads to a disconnect between their perceived and actual economic welfare. This cognitive bias can result in a sense of dissatisfaction and diminished well-being, even if their real income remains relatively stable.

To understand the impact of high inflation on perceived well-being and the behavioral choices that come with it, it is important to understand some of the main drivers of how inflationary expectations are shaped. The manner in which inflation and its potential impact are portrayed in different media outlets can significantly influence one’s expectations and perceptions. Alarmist reporting on rising prices and the cost of living tends to hold more weight and fuel anxiety and exaggerated concerns about its impact, compared to more neutral or played-down reporting. Another driving factor of how expectations about inflation are shaped is an individual’s political affiliation. In research done by Bachmann et al. (2019) examining partisan bias in inflation expectations, they find that “The results show that inflation expectations were 0.46 percentage points higher in Republican-dominated than in Democratic-dominated US states when Barack Obama was US president. Compared to inflation expectations in Democratic-dominated states, inflation expectations in Republican-dominated states declined by 0.73 percentage points when Donald Trump became president.”  People who align with the current governing party may be more inclined to trust official projections and have more moderate expectations, while those in opposition may be more skeptical and anticipate higher inflation rates. The research also shows right-leaning individuals carry this bias more heavily, especially due to the Democratic party’s focus on lower-income groups and unemployment.

Research finding that European households exposed to higher inflation rates in the past report significantly lower life satisfaction scores today (Cupak et al., 2023) highlights the long-lasting impact inflation can have on how people feel about their overall well-being. This suggests that inflation is rooted in emotional responses and psychological biases. Merely experiencing higher inflation could decrease someone’s overall satisfaction, even after inflation levels go down. Emotions tied to one’s purchasing power and standard of living being eroded may leave a strong psychological imprint.

This imprint can carry over into behavioral changes, specifically in financial markets as highlighted by Basak et al. (2010), “money-illusioned investors essentially discount future real payoffs at nominal rather than real rates, causing the undervaluation of stocks in the 1970s when inflation was excessively high.” This tendency to evaluate investments and financial decisions based on nominal rather than real values can lead to suboptimal choices and missed opportunities. Additionally, Basak et al. (2010) note that “at a partial investor’s real consumption is decreasing in the price level (holding all else fixed).” This suggests that even if an individual’s real income remains constant, the psychological impact of inflation may lead them to reduce their consumption levels and potentially dampen economic activity.

A notable phenomenon observed across various datasets, countries, and time periods is the tendency for households and firms to consistently overestimate future inflation rates, as highlighted by Weber et al. (2022), “the average and median numerical inflation expectations of households and firms tend to be higher than the realized inflation rates that occur subsequently, and also higher than the contemporaneous inflation expectations of professional forecasters and financial-market participants.” This systematic overestimation of inflation by the general public, in contrast to the more accurate predictions and expectations of market participants, underscores the universal display of money illusion. The disconnect between perceived and actual inflation rates can further amplify the negative impact on individual’s perceptions of well-being during periods of high inflation. When people consistently expect higher inflation than what ultimately materializes, it can reinforce the sense of eroding purchasing power and diminish perceived economic welfare, even if the real effects of inflation are less severe than anticipated.

Moreover, these exaggerated inflation expectations may prompt preemptive behavioral changes, such as reduced consumption or changes in investment decisions, which may have broader economic implications. “Intuitively, when households anticipate higher price growth in the future, they should choose to consume more today before those price increases materialize. Spending on durable goods should be affected most, because they are easier to substitute intertemporally than non-durable goods.” (Weber et al. 2022) This suggests that money illusion and inflated inflation expectations may lead households to cut back larger purchases or delay the purchase of durable goods. Furthermore, money illusion can influence individual decisions beyond just consumption and savings choices. As Botsch et al. (2020) points out, “inflation expectations should also influence individual decisions about borrowing, including their mortgage choices.” When people overestimate future inflation rates, they may adjust their borrowing strategies in ways that could be suboptimal or carry unintended consequences for their long term financial well-being. These behavioral adjustments which are driven by the disconnect between perceived and actual inflation rates can have ripple effects throughout the economy causing reduced consumption and consumer confidence as well as altered investment decisions. These changes can impact growth and overall financial well-being.

The effects of high inflation influence the broader population by altering behaviors, specifically consumption and investment decisions, however, high inflation can also disproportionately affect different income groups. The backbone of this effect is highlighted by Kahar et al. (2019) where “an increase in anticipated inflation raises the cost of holding money and thereby reduces consumption for all but more so for the poor households since they finance a higher fraction of their consumption using money.” Lower-income households tend to have a higher portion of their wealth in the form of cash. This causes a more rapid erosion of purchasing power during inflationary periods compared to higher income households. Higher earners may be more protected from higher inflation rates as they have a more significant amount of their wealth invested in assets such as real estate or stocks which could act as a hedge against inflation. Moreover, the central bank’s primary tool to combat high inflation is to tighten monetary policy aiming to restore price stability. The rise in borrowing costs associated with higher interest rates can disproportionately impact lower-income households, as they often have limited bargaining power and may receive less favorable lending terms due to their credit history compared to higher-income counterparts.

Combating Money Illusion

Money illusion and perceived well-being can have significant impacts on the economy and financial decisions. That is why, what could be done to minimize the effects is a challenge economists and policymakers have been facing for a while. There are multiple ways of fighting these challenges and educational attainment plays a major role in combating such issues. The basis of money illusion is people do not understand financial terms or are not even aware of such things in the first place, so they get confused when they hear things like “inflation,” “monetary policy” etc. because they do not know how that affects them. One way to face that is by making schooling more accessible and to opt-in high school students and above into an economics education class. By integrating economics education into the curriculum, students gain exposure to essential financial terms and concepts like inflation, monetary policy, and investment. This would improve and ensure a higher level of financial knowledge among individuals which would benefit the economy as a whole. Opting in students into these economics educational classes would greatly impact the number of informed individuals as “Automatic enrollment significantly increases participation.” (Sunstein, C. 2013). These economic classes would allow individuals to make better-informed financial decisions like investing, consumption, etc. because “people tend to suffer less from money illusion when they are more financially literate. This effect is due to financial knowledge which improves by education.” (Celiktas 2021). When individuals understand financial terms and their implications, they are less likely to make decisions solely based on nominal values (like dollar amounts) and more on real values (purchasing power). This leads to more effective financial planning and decision-making. Overall, if the population as a whole starts making better informed financial decisions, this could lead to economic development as well.

Adjusting the public education system would aid in making schooling more accessible and mitigating money illusion effects. Public schools in an area are funded by property tax in that area. So if an individual resides in a low-income area, the educational resources and opportunities available to them are either poor or not as good as those in a high-income area. This means that a poverty-stricken urban area will be underfunded compared to a high-income earning area, leading to inequality in education, financial illiteracy, and income inequality. Children who are born into poor areas and exposed to poor education are less likely to invest in their education. This means they will be at a disadvantage and be less financially literate, and therefore, make poor and unadvised financial decisions. As this cycle repeats, poverty keeps repeating itself as intergenerational mobility is limited to achieve with poor funding of education. Making the funding for schools equal across different districts despite income levels in the area would be beneficial for the whole economy. Gentrifying poor income areas could also possibly aid in this but could also have adverse effects like families needing to move out of their homes so further investigation would be needed.

Education is closely linked to economic outcomes, including income levels. Accessible schooling and financial education can help shorten wage gaps by equipping individuals with skills and knowledge that lead to higher earning potential and better financial management. Making schooling more accessible would also allow more individuals to experience returns to education which not only shortens the wage gap, but also goes hand in hand with money illusion as “higher income, GPA, and class standing relates to higher financial knowledge.” (Celiktas 2021). Accessible education ensures that more people, regardless of socioeconomic background, have the opportunity to develop financial literacy. A younger generation will have a better chance at financial success if they can correctly understand and use financial tools, so raising financial literacy can also increase intergenerational mobility. This allows individuals to build wealth and achieve greater economic mobility, which can positively impact future generations and prepare them for issues like money illusion.

In order to combat money illusion and perceived well-being in another way, we must dive into behavioral economics. Behavioral nudges and interventions can be used to counteract cognitive biases. When people know about the benefits or risks of certain actions, they are more likely to act under that information if they are provided with a clear guideline about how to do so, but where do they get their information from? Media sources like the news or newspapers can have effects on people and their behavior as “people are influenced by how information is presented or “framed.”” (Sunstein, C. 2013). For example, Sunstein states that if people were informed they would gain a certain amount of money by using energy-efficient products, they may be less likely to adjust their behavior than if they were told they would lose the same amount of money by not using such products. What this goes to show is that if the media perhaps told their viewers that they would have much fewer savings accumulated if they saved cash compared to retirement plans, they are more likely to react to that than if they were told their accumulated savings would be higher in retirement plans. This is because people display loss aversion and may well dislike loss more than they like corresponding gains. Additionally, if the media vividly informs viewers about economic conditions, it may have a larger impact rather than sharing statistical and abstract information. If the media station brings attention to current economic issues like inflation, then consumer sentiment can be influenced beneficially. “Tracking narratives in news media may provide policymakers with early warnings of changes in consumer sentiment” but if the central bank can coordinate with such narratives and media, then this could be a powerful tool for macroeconomic stabilization which would minimize the negative effects of money illusion (Macaulay et al.,  2022).

Automatic enrollment in retirement plans and increased awareness of investment options can empower individuals to overcome money illusion and make meaningful contributions to their long-term financial security. Some individuals work their whole lives imagining a comfortable and happy retirement but how do they save up for such a thing? Some people do not believe in the financial system of today’s world and store all their accumulated savings under their pillow, some store money in the bank gaining minimal appreciation every year, and some individuals do not have savings. Automatic enrollment in retirement plans such as 401(k)s and IRAs can incentivize individuals to save for their future without requiring critical decision-making. Investment plans are usually used by more financially literate individuals, while the majority of the public with any level of savings choose to invest through 401(k)s and IRAs because they heard about them through the media.

For anyone expecting to indulge in a comfortable and wealthy retirement, financial instruments like 401(k)s, Individual Retirement Accounts, or IRAs, and fixed income can provide a guideline for such and provide various benefits. One of these benefits is that these instruments are tax-deferred meaning they accumulate value over time, and when you can withdraw, none of it is taxed. Additionally, having a diverse investment and asset portfolio can ensure consistent savings and investment toward retirement goals, regardless of market fluctuations or short-term financial perceptions. Access to diverse investment options can also potentially lead to higher returns over time compared to keeping savings in low-yield accounts or under the mattress. A study looking into the automatic enrollment into pensions within small businesses in the UK and the US stated, “Despite automatic enrollment increasing pension participation among those working for small employers to 70 percent, this remains well below the 90 percent levels seen among medium-sized and larger employers both in the United Kingdom and the United States.” (Cribb 2021). A possible reason for the variation in participation levels could be individuals have to make investment decisions largely based on their own knowledge and that can be very challenging for somebody far from the financial industry.  “Only a small fraction of households consult financial advisers, bankers, certified public accountants, and other professionals, while the majority of households rely on informal sources of advice.” (Lusardi 2008). Investment varies and does not 100% guarantee high returns, but if there was a government hotline where one could call and ask about the current economic conditions, possibly that would help as access to financial professionals may not be feasible or may be intimidating for individuals. If individuals started to rely more on receiving professional financial advice, it could help them make smarter financial decisions even with a low financial literacy of their own.

Conclusion

This chapter has explored the deep connections between money illusion, inflation, and how people perceive their economic well-being. At the core, the psychology of money illusion shows that individuals often misinterpret changes in nominal wealth or income without properly accounting for inflation’s erosive effects. This distortion in thinking stems from the distinct ways our brains respond to monetary incentives compared to how we mentally represent and process information.

Money illusion isn’t just limited to individual psychology, it has major cultural and societal impacts as well. Examples explored from countries like Indonesia, Ghana, and Germany portray how ingrained this phenomenon can get. Policies intended to simplify currency units have backfired by distorting spending behaviors driven by perceived self worth changes, and historical episodes of severe inflation such as in Germany’s stock market, demonstrate how money illusion can distort investment decisions and market efficiency. The prevalence of money illusion during inflationary periods has had large ripple effects across economies and economic policy making. When individuals suffer from money illusion, it skews decisions around consumption patterns and borrowing behavior.

High inflation directly impacts people’s sense of well-being and behaviors. Things such as media framing of inflation news and partisan biases shape how people form expectations about future inflation. This could cause anxiety and over exaggerated concerns about eroding purchasing power. In turn, this prompts people to make suboptimal financial decisions such as reducing consumption or shifting investment strategies. While these behavior changes impact individuals, it can have broader implications that can restrain economic growth and worsen income inequality.

Increasing financial literacy through more accessible education is key to empowering people to make more well informed choices without falling subject to cognitive biases such as money illusion. Using nudges drawn from behavioral economics and coordinating narratives with media can also counteract some of the distortions in decision making. However, it is not always so simple to negate the effects of money illusions grasp on shaping human behavior.

Getting a handle on the relationship between money illusion, inflation and perceived well-being is crucial for promoting well-informed and efficient economies. Without addressing this relationship, individuals will continue to make poor monetary decisions that can hinder the economy. When large groups of people struggle with money illusion, it can have negative implications on how markets and societies function. The psychological, cultural, and social factors involved require well-rounded solutions, but the first step is to understand and address what’s causing the problem in the first place.

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