Don't Ignore Inflation Ignorance: On the Relevance of Money Illusion for Economic Modeling

Abstract

Money illusion refers to the tendency to evaluate economic transactions in nominal rather than real terms. One manifestation of this phenomenon is the tendency to neglect future inflation in intertemporal investment decisions. Empirical evidence for this “inflation ignorance” is hard to establish due to the host of factors that simultaneously change with the inflation rate. We avoid these identification issues by conducting a controlled and fully incentivized investment experiment. We measure a substantial degree of money illusion and show that it is not driven by lacking diligence, arithmetic problems, or misunderstandings of inflation. Instead, participants seem to anchor subconsciously to nominal returns, even though they are unambiguously incentivized to base their decisions on real returns only. Our findings contribute towards understanding various anomalies on the individual and market level, such as insufficient savings efforts or equity mispricing.