Money Illusion Research Articles

International Transmission of Shocks, Money Illusion and the Velocity of Money

Money illusion is frequently invoked and frequently resisted by economists. Resisted as it contradicts the maximizing paradigm of microeconomic theory and invoked since a tendency to think in nominal rather than real terms becomes evident in the behavior of agents. This paper rationalizes money illusion in an stylized open economy model considering that private agents learn nominal aggregate demand at a level different from the one imposed by rationality. We find that the welfare effects of a productivity shock are increasing in the degree of money illusion and decreasing in the degree of openness of the economy. Furthermore we introduce a velocity of money shock revisiting the Quantity Theory of Money within the open economy micro-founded framework. An incomplete information game between Home and Foreign policymakers with monetary policy rules is developed, where sudden unstable financial conditions arise in one country, to find that allowing for velocity shocks reinforces the need for optimal monetary policy rules and to open the economies in order to avoid welfare costs.

Trend of Average Wages as Indicator of Hypothetical Money Illusion

Trend of Average Wages as Indicator of Hypothetical Money Illusion

Money Illusion Phenomenon Among Middle-Lower Income People in Jakarta Indonesia

This research tries to study money illusion phenomenon among middle-lower income people living on the area Jakarta. Questioner adopted from Pujiastuti (2001) which modifies Shafir’s et al.(1997) is used to interview 90 respondents finding their attitude on 2 aspects of money illusion, i.e. income and transaction. Respondent background, such as education, job, monthly spending, and their role on family’s spending are used to find the relationship between the phenomenon and the background. The results show people are not illusion free on transaction. While, the role on family’s spending is not independent to transaction aspect. This study also tries to give a comprehensive view of Indonesian People behavior on money illusion phenomenon

Inflation, Real Stock Prices and Earnings: Friedman Was Right

Milton Friedman argued that inflation imposes real costs on the economy, in particular, by decreasing firms’ real earnings. This implies a negative correlation between realized inflation and real stock prices. While we do observe such negative correlation, there has so far been scant evidence that inflation is indeed bad for real earnings. This has led authors to favor behavioral theories, such as money illusion. In this paper I test for real channels by using data on Emerging Markets. These have the advantage of offering high variation in inflation both across time and countries. Results provide robust evidence for real channels in three ways. First, there is a negative correlation between realized inflation and future real earnings, as Friedman (1971, 1977) claimed. Second, inflation correlates positively with risk, as recently discussed in Bekaert and Engstrom (2010). Third, as suggested by Ritter and Warr (2002), leverage ameliorates the negative correlation between inflation and real stock prices.

Explaining the Stock Price-Inflation Puzzle: Inflation as a Signal for a Rare-Event

This paper explains the negative correlation between realized inflation and real stock prices under a rare-event framework. Agents make use of realized inflation rates to update their beliefs on the time-varying probability of a rare-event (stagflation or hyperinflation). A higher stagflation probability implies a higher correlation between inflation and real stock prices (dividend yield). I show that for a Bayesian belief-updating agent, the expectation on the Fed commitment to low inflation is key in order to explain the magnitude of the correlation. To test the model predictions, I perform a Markov Regime switching estimation and identify two statistically different regimes: one regime in which agents expect a strong commitment to low inflation by the Fed; and another regime in which they expect a low commitment to low inflation. Inflation correlates higher with stock prices in the second regime than in the first one. Finally, I show that the rare-event approach is more robust than the money illusion approach a-la Modigliani and Cohn (1979).

Illusion — Money — Illusion: Viktor Pelevin and the 'Closed Loop' of the Vampire Novel

A brief contextual discussion is presented of the Russian history of the vampire genre and its spiritual critique of the human condition in both the nineteenth and twentieth centuries, encompassing texts by Gogol, Turgenev and Bulgakov, as well as the well-known Dozor teratology by Sergei Luk'ianenko). It addresses the question of whether the vampire in this context is principally Romantic transgressor, moral object lesson, political metaphor, or capitalist bloodsucker. The principal focus of the article is Viktor Pelevin's 2008 novel Ampir V (Empire V), set in a new Russian empire of 'benevolent' slavery, in which humans are prey to the vampires who live amongst them. The argument is that Pelevin's novel addresses issues such as political predation, capitalism, and consciousness; the mind-capital link can be analysed within a broadly Jamesonian/Deleuzian model of consciousness under late capitalism. Pelevin uses vampires, hidden creatures of the night, to divine the darkness of self-delusion, asking what one might know and how one might know it, given a world of illusions, shadows, and deception. Although (briefly) acknowledging the forces of faith and of love, he concludes that addiction to illusion is the human condition; thus Pelevin's formulation of human destiny as 'illusion–money–illusion'.

Is There a Link Between Money Illusion and Homeowners’ Expectations of Housing Prices?

Money illusion is a behavioral bias in which a person thinks in terms of nominal rather than real values. This article reports homeowners’ responses to a survey designed to measure the extent of money illusion as well as homeowners’ expectations regarding home valuations. Our survey respondents suffer from money illusion, yet they have reasonable expectations of home prices. Our analysis did not identify any unique individual characteristic that correlates with homeowners’ choices and suggests that the relationship between money illusion and mispricing is subtle and multifaceted.

Devaluation as the instrument for recession overcoming in Bosnia and Herzegovina

Devaluation is the instrument of monetary policy which has been used very often during the 20th century. In recent time of globalization, the many limited factors (openness of the economy, capital movements, currency substitution, money illusion) significantly reduce or completely make impossible the devaluation implementation as the measure for foreign trade deficit or recession overcoming in many countries. This paper discusses on positive and negative effects of devaluation in the case of Bosnia and Herzegovina economy.

How People Respond to the Changes in Nominal and Real Values in the Presence of Money Illusion?—Evidence from an Experiment in Japan—

How People Respond to the Changes in Nominal and Real Values in the Presence of Money Illusion?—Evidence from an Experiment in Japan—

Money Illusion and Rational Expectations: New Evidence from Well Known Survey Data

This paper provides further evidence in favor of less than fully rational expectations by making use two instruments, one quite well known, and the other more novel, namely survey data on inflation expectations and Smooth Transition Error Correction Models (STECMs).We use the so called 'probabilistic approach' to derive a quantitative measure of expected inflation from qualitative survey data for France, Italy and the UK. The United States are also included by means of the Michigan Survey of Consumers' expectations series. First, we perform the standard tests to assess the 'degree of rationality' of consumers' inflation forecasts. Afterwards, we specify a STECM of the forecast error, and we quantify the strategic stickiness in the long-run adjustment process of expectations stemming from money illusion. Our evidence is that consumers' expectations do not generally conform to the prescriptions of the rational expectations hypothesis. In particular, we find that the adjustment process towards the long-run equilibrium is highly nonlinear and it is asymmetric with respect to the size of the past forecast errors. We interpret these findings as supporting the money illusion hypothesis.

Tax Perception - An Empirical Survey

This paper gives a survey of the experimental literature on the perception (bias) of individuals with respect to their own tax burden and its effect on economic decisions. Six strands of literature are discussed: (1) perception of marginal tax rates, (2) influence of tax complexity on tax perception, (3) taxation and incentives to work, (4) tax salience, (5) tax morale and fairness and (6) money illusion, perceived inflation and fiscal drag. The literature discussed contains more evidence for than against a perception bias.

Expected inflation, expected stock returns, and money illusion: What can we learn from survey expectations?

We show empirically that survey-based measures of expected inflation are significant and strong predictors of future aggregate stock returns in several industrialized countries both in-sample and out-of-sample. Empirically discriminating between competing sources of this return predictability by virtue of a comprehensive set of expectations data, we find that money illusion seems to be the driving force behind our results. Another popular hypothesis – inflation as a proxy for aggregate risk aversion – is not supported by thedata.

Deceiving Our Minds: A Qualitative Exploration of the Money Illusion in Post-redenomination Ghana

The current study is a qualitative exploration of the presence of the money illusion in the lived experiences of Ghanaian adult consumers after a currency redenomination. The results indicated that a switch from the old currency to the new currency had implications for self-worth determination, trivialization of price increases, changes in spending behaviour, and changes in the extent of benevolence. All these changes were related to the tendency to make judgments based on the nominal value of an amount of money, rather than its real value; the judgment bias is known as the money illusion.

The Effect of Earnings‐Based Metrics on Vertical Efficiency

The tendency to rely on accounting earnings as the primary metric of corporate performance has been subject to criticism in recent times. A key concern is that earnings misrepresent changes in value in that cash outlays occur upfront but expenses are recognized only over time. While recognized expenses indeed add up to the initial cash outflow, the equality holds only in undiscounted (nominal), not discounted (real), terms. Accordingly, corporate earnings figures suffer from a form of money illusion. In this paper, we demonstrate that such money illusion can have an upside when it is present in vertical relationships subject to self‐interest. In particular, a buyer who focuses on earnings has incentives to increase purchases since it does not immediately encounter the full cost of cash outflows. These added incentives can promote more efficient trade. We also show that the increased incentives to buy can also lead to Pareto improvements by spurring the supplier to invest more in developing technology. Finally, we demonstrate that judiciously chosen inventory valuation rules can lead to efficient supply chain outcomes. Thus, efficiency can be achieved when supply chain parties freely trade and regulators specify only the accounting rules under which they operate.

Stock Market Mispricing: Money Illusion or Resale Option?

Stock Market Mispricing: Money Illusion or Resale Option?

A tale of two Cedis: Making sense of a new currency in Ghana

Ghana (West Africa) underwent a currency change in July 2007. This paper explores the adaptation to the New Ghana Cedi one year post-redenomination using the theoretical framework of the Money Illusion Effect and the relearning–rescaling hypotheses. Study 1 revealed that the old and new currencies appeared to be valued similarly, based on the ratings of gains and losses in the old and new currencies. This result is consistent with the slogan of the Ghanaian redenomination public education campaign and suggests that people can be inoculated against the Money Illusion Effect through education. In study 2, attributes of the new currency were rated more positively than those of the old currency, suggesting a preference for the New Ghana Cedi.

Equilibrium Asset Prices and Investor Behaviour in the Presence of Money Illusion

This article analyses the implications of money illusion for investor behaviour and asset prices in a securities market economy with inflationary fluctuations. We provide a belief-based formulation of money illusion which accounts for the systematic mistakes in evaluating real and nominal quantities. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its welfare cost on investors is small in typical environments. A money-illusioned investor's real consumption is shown to generally depend on the price level, and specifically to decrease in the price level. A general-equilibrium analysis in the presence of money illusion generates implications that are consistent with several empirical regularities. In particular, the real bond yields and dividend price ratios are positively related to expected inflation, the real short rate is negatively correlated with realized inflation, and money illusion may induce predictability and excess volatility in stock returns. The basic analysis is generalized to incorporate heterogeneous investors with differing degrees of illusion.

Straightening the Phillips curve, 1968–1976

This paper looks at the change in the British Treasury's macroeconomic thinking between Friedman's statement of the natural rate doctrine in 1968 and Prime Minister Callaghan's public abandonment of Keynesian demand management in 1976. Simultaneously rising unemployment and inflation made the Treasury sceptical about the old Phillips curve from the start, but, far from moving smoothly to the expectations-augmented version, it hesitated between assuming the curve had shifted outwards, abandoning any idea of a Phillips curve, and adhering to a ‘New Cambridge’ curve where unemployment made inflation worse. Eventually a tense Treasury meeting abandoned money illusion by majority vote.

The Problem of Money Illusion in Economics

Money illusion in economic theory has been an assumption rejected for academic economists for quite some time. However, with the gradual diffusion of behavioural economics based on experimental research this has changed. Now, it has become a respected fact to accept money illusion as a stylized fact of human behaviour. However, it still needs a better understanding why monetary phenomena especially related to financial markets play an important role in understanding the real economy, the production, consumption and exchange of commodities and services. The author of this paper suggests that financial markets are particular engaged in intertemporal valuation problems which are common to any kind of economic activity. Since money is the unit of account, accounting problems related to the uncertain nature of future economic development makes a continuous readjustment of valuations in money units necessary. However, financial markets are imperfect as Minsky has pointed out. Because of these imperfections the possibility of significant long-lasting valuation problems emerges. One reason for this is that in standard economic reasoning the problem of intentional cheating is neglected. Furthermore major innovations like e.g. the ICT revolution with the Internet or the introduction of securitization as a means to redistribute risk as general purpose innovations make valuations of the long term to medium term impacts on the economy extremely difficult. The recent financial market bubbles are significantly related to such general purpose innovations. If monetary policy fails to control for irrational exuberance of investors about the future benefits and profits of such innovations, this inherently embodies the risk of a financial market shock, if expectations of the general public have to adjust after overoptimistic prediction about the future economic development. The author, however, considers that there are some early warning indicators which would give the possibility of timely action of policy makers to control financial market bubbles. The complacency of monetary authorities of the past decades to do so, has not primarily a diagnostic problem to deal with money illusion, but even more so with vested interests of insiders of private investors on the institution to control unlawful behaviour. By weakening the regulatory framework, failing to establish transparency and accountability of agents eager to get rich as fast as possible without taking into regard the rules of good governance the current global financial crisis of institutional failure to contain the instability of financial markets to an acceptable social level. Money illusion is so as well an expression that unfounded optimism about the self-regulatory discipline of market participates is sufficient to stop financial markets get out of control to an historical unprecedented level.

Expected Inflation, Expected Stock Returns, and Money Illusion: What Can We Learn from Survey Expectations?

We show empirically that survey-based measures of expected inflation are significant and strong predictors of future aggregate stock returns in several industrialized countries both in-sample and out-of-sample. Empirically discriminating between competing sources of this return predictability by virtue of a comprehensive set of expectations data, we find that money illusion seems to be the driving force behind our results. Another popular hypothesis - inflation as a proxy for aggregate risk aversion - is not supported by the data.