Abstract
A basic principle of economics is that people always prefer a larger set of opportunities. Money illusion can be considered as the phenomenon when people may not correctly perceive their budget constraints, and may act in ways that run counter to this preference. In this interpretation, money illusion is a cognitive bias, worthwhile to overcome. Herein I argue that taking a view of human decision-making based on certain strands of cognitive psychology, one can reinterpret the evidence for money illusion in two ways. First, I claim that money illusion is inescapable to some extent, and saying that we suffer from it is similar to alleging that we experience optical illusions, only because we are unable to see, say, individual atoms. Second, taking a view on “preferences” different from the traditional one, I contend that it may bring little benefit to get rid of money illusion even in the cases where it is possible to do so. To follow up the visual analogy, even if we can improve our eyesight it is not obviously desirable. These arguments seem to lead to a Candidean disposition: there is no possible improvement on the state of affairs as far as “money illusion” is concerned. Nonetheless, I will make some positive proposals concerning economic policy and economics research.
Highlights
Please notice that I’m not sarcastic: despite the fact that I’m going to offer a view that is different from this, I must acknowledge that the traditional conceptual framework of economics with preferences or utilities defined on the states of nature is a great intellectual achievement, certainly superior to naïve or folk economic ideas that have no notions of real money, price-indices, direct and indirect utilities and so on
This study indicates that money wage cuts are regarded as unfair and are feared to destroy morale within firms, with the attendant negative consequences on productivity and future hiring
Lea and Webley (2006) argue that money illusion is incompatible with what the authors call the Tool Theory of Money, whereby money is a means for achieving certain goals
Summary
Economic textbooks assert that money is, first of all, a means of exchange (see, for instance Mankiw 2009, Ch. 21). Clower (1967) defined it more formally: money is a commodity that is exchangeable for (almost) any other commodities. The textbooks proceed by telling us that money has other functions, such as store of value and unit of account. Most economic models make the additional assumption that money is a good that does not enter directly into the utility functions of agents, or, in other words, it has only indirect utility. Please notice that I’m not sarcastic: despite the fact that I’m going to offer a view that is different from this, I must acknowledge that the traditional conceptual framework of economics with preferences or utilities defined on the states of nature is a great intellectual achievement, certainly superior to naïve or folk economic ideas that have no notions of real money, price-indices, direct and indirect utilities and so on. Cognitive psychology has progressed even in ways of formal modelling, giving us hopes that its otherwise well-known achievements can be readily adopted by economists who have developed a predilection for mathematical models as a necessary precondition for a theory
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