Money Illusion Research Articles

On the Perceived Value of Money: The Reference Dependence of Currency Numerosity Effects

Money illusion research shows that the nominal (face) value of money affects consumer perceptions of its real value. Recent mixed findings on consumer valuations in different currencies suggest that the underlying anchoring and adjustment processes are complex. We develop a framework to identify boundary conditions that specify the direction of anchoring effects on valuations in different currencies. Consumers anchor on the numerosity of the nominal difference between prices and salient referents (e.g., budgets) when evaluating transactions. Support for our framework comes from a series of experiments that evoke different reference standards. We discuss implications and opportunities for future research.

Prospect-theory’s Diminishing Sensitivity Versus Economics’ Intrinsic Utility of Money: How the Introduction of the Euro can be Used to Disentangle the Two Empirically

The introduction of the euro gave a unique opportunity to empirically disentangle two components of utility: intrinsic value, a rational component central in economics, and the numerosity effect (going by numbers while ignoring units), a descriptive and irrational component central in prospect theory and underlying the money illusion. We measured relative risk aversion in Belgium before and after the introduction of the euro, and could consider changes in intrinsic value while keeping numbers constant, and changes in numbers while keeping intrinsic value constant. Intrinsic value significantly affected risk aversion, and the numerosity effect did not. Our study is the first to confirm the classical hypothesis of increasing relative risk aversion while avoiding irrational distortions due to the numerosity effect.

Money illusion in intuitive financial judgments: Influences of nominal representation of share prices

We report two experiments to demonstrate the money illusion in intuitive financial judgments. In Experiment 1 we assess the extent to which the nominal representation affects participants’ expectations of changes in share prices following negative or positive financial information. In support of an anticipated bias towards the nominal representation, a lower share price was found to lead to higher expected percentage changes. Experiment 2 investigates equivalent effects for share prices represented in euros or Swedish crowns (approximately equal to 0.1 euro). Here shares represented in the more expensive euro resulted in higher expected percentage changes in share prices, hence replicating the results of Experiment 1. A third experiment was also conducted where we demonstrate how changes of nominal prices affect participants’ trading following a split or a reverse split of share prices. The results show that both buyers and sellers were more willing to trade shares after a split, whereas the opposite was true after a reversed split.

Impact of the Real Median Price of Single-Family Homes on Geographic Mobility, 2000-2005

The present study investigates the impact of the real median price of single-family homes on net internal migration flows in the United States over the 2000-2005 period. After allowing for factors such as the growth rate of GSP, the presence of hazardous waste sites, climate, per capita state income taxes, and other factors, it is found that the net state inflow of migrants over the 2000-2005 period was negatively and significantly affected by higher real median prices on single-family homes, a finding consistent with the absence of ‘‘money illusion’’ in the migration decision.

Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models

There has been a widespread perception in the past few years that long-term asset prices are generally high because monetary authorities have effectively kept long-term interest rates, which the market uses to discount cash flows, low. This perception is not accurate. Long-term interest rates have not been especially low. What has changed to produce high asset prices appears instead to be changes in popular economic models that people actually rely on when valuing assets. The public has mostly forgotten the concept of real interest rate. Money illusion appears to be an important factor to consider.

Unfinished Business in the Macroeconomics of Low Inflation: A Tribute to George and Bill by Bill and George

THE RETIREMENT OF GEORGE Perry and William Brainard as editors of the Brookings Papers gives us an opportunity to say publicly what we have often said privately: the Brookings Papers is an important national institution. It is important because it has set the right tone for U.S. macro-economic policy. George and Bill are both Keynesians, not just in the narrow tradition of IS-LM models with Phillips curves, but also in their broader methodological approach to macroeconomics. Brookings Papers has always reflected their view that macroeconomics should be a pragmatic and judicious mixture of theory and common sense, informed by statistical analysis. That of course reflects the methodology of Keynes, throughout his life and especially in General Theory. We think that U.S. macroeconomic policy has benefited enormously from such a balanced pragmatic-empirical approach. Anyone who doubts the benefits of such an approach to macroeconomics needs only look to the north--to Canada--where doctrinaire use of an extreme form of natural rate theory in the 1990s led policymakers to push inflation too low, resulting in an unusually wide unemployment gap relative to the United States. This is just one example where a more empirical, more nuanced macroeconomics--such as presented for the last thirty years in the Brookings Papers--has implications for national welfare. Macroeconomic policy, as no one appreciated better than Keynes, often even makes the difference between prosperity and depression. It will be a hard task for the new editors to take the place of George and Bill, and we wish them luck. Neither this Bill nor this George has ever envied George and Bill their difficult job. They have edited the Brookings Papers the hard way. easy way is to trawl the conferences and the economics department hallways for the best of what already exists. Instead, for the most part, George and Bill recruited people to push forward their pragmatic agenda for macroeconomic research. influence of George and Bill, even in the late stages of producing these papers, is clear to all members of the Brookings Panel. We have continued to be amazed at how George and Bill could take the meeting drafts, which were not always in the best of shape, and quickly tuna them into interesting, readable gems. In short, they have done the impossible: admittedly with some very good help from their authors, they have produced something like eight to twelve significant and relevant new papers on macroeconomics per year, year after year. Some Background on This Paper This volume in honor of George Perry and William Brainard is an opportunity to reflect back on the two Brookings Papers we wrote with Perry (with comments and occasional help from Brainard) on the macroeconomics of low inflation. (1) Although they took somewhat different approaches, these two papers had similar policy implications. Both found a significant cost of permanently low inflation in terms of permanently high unemployment. Each paper examined the effects of a different type of money illusion. earlier paper, The Macroeconomics of Low Inflation, examined the consequences of downward nominal wage rigidity, or resistance to nominal wage cuts. Near-Rational Wage and Price Setting examined the consequences of people thinking in nominal rather than in real terms when inflation is very low. When this happens, a trade-off will emerge between inflation and unemployment--not just in the short run, but also in the long run when actual inflation and expected inflation are equal. Although the existence of such a trade-off was previously well known, its magnitude was not. Both papers found surprisingly large long-run increases in unemployment from permanent reductions in inflation to zero. For example, in the benchmark simulation in the first paper, with limited nominal wage cuts for continuing workers, we found that a permanent reduction in annual inflation from 2 percent to zero would increase unemployment by 1. …

Money illusion under test

We propose a test for the presence of money illusion based on subjective survey information on individual satisfaction with income. Using data from the German Socio-Economic Panel for the period 1993–2003, we cannot reject the null hypothesis of no money illusion.

A Brief Inventory of Behavioral Influences on the Subjective Risk Adjusted Discount Rates in Project Appraisal

Behavioral finance has emerged as a new paradigm in financial economics. It deals primarily with the influences of psychology on market finance and with market inefficiencies. The field of psychology, already very present in organizational psychology and decision-making, is slowly opening up applications in corporate financial decisions and more specifically in corporate finance techniques. Among these corporate finance decisions is the project evaluation decision or the investment decision. This is based on first calculating expectations and risk estimates and then making a decision. This paper looks at how psychology can influence on the calculation of subjective risk estimates which are used to evaluate projects. We break down the risk factors used in project finance as the real time value of money, perceptions of inflation, market risk and Beta , financial risk and firm-specific risk and study some psychological factors which can influence each of these and why these may be important. The psychological factors we study in this paper include patience and impatience, optimism and pessimism, the notion of time in different cultures, inter-temporal differences/ dynamic inconsistency, inner tempo, achievement orientation, past or future orientation, addiction, frequency of evaluations, horizon / myopia, money illusion, loss aversion, values and lifestyles, agency problems,organizational decentralization, adverse selection, limited liability, venture capital firms, qualitative projects, example human capital, familiarity bias, confidence and hubris.

Wage incentives and wage rigidity: A representative view from within

A recent literature has used surveys of those who set wages to learn about the nature of wage incentives and the sources of wage rigidity. Methodologically, we overcome many of the objections that have been raised against this work. Substantively, we find that: (i) the reasons for real wage rigidity differ significantly between large and small firms, and between the high- and low-end of the labor market; (ii) efficiency wage mechanisms reinforce rigidities due to worker bargaining power; (iii) money illusion is a widespread phenomenon across all segments of the labor market; (iv) unions reinforce nominal wage rigidities due to external pay comparisons; (v) there appears to be gender differences in pay bargaining and work morale.

Devolution of the Fisher Equation: Rational Appreciation to Money Illusion

In Appreciation and Interest Irving Fisher (1896) derived an equation connecting interest rates in any two standards of value. The original Fisher equation (OFE) was expressed in terms of the expected appreciation of money [percent change in E(1/P)] whereas the ubiquitous conventional Fisher equation (CFE) uses expected goods inflation [percent change in E(P)]. Since Jensen's inequality implies the non-equivalence of the two equations, the OFE is not subject to standard criticisms of non-rationality leveled against the CFE. The puzzling substitution of inflation for expected money appreciation in Fisher (1930) is resolved by taking into account Fisher s theory of money illusion.

Money illusion and coordination failure

Economists long considered money illusion to be largely irrelevant. Here we show, however, that money illusion has powerful effects on equilibrium selection. If we represent payoffs in nominal terms, choices converge to the Pareto inferior equilibrium; however, if we lift the veil of money by representing payoffs in real terms, the Pareto efficient equilibrium is selected. We also show that strategic uncertainty about the other players' behavior is key for the equilibrium selection effects of money illusion: even though money illusion vanishes over time if subjects are given learning opportunities in the context of an individual optimization problem, powerful and persistent effects of money illusion are found when strategic uncertainty prevails.

Cognitive and emotional factors affecting currency perception

Money illusion effect describes the fact that people have the tendency to use the nominal value as an anchor when evaluating the value of goods, and that they neglect the real value of money. In this research we focus on both cognitive and emotional modifications of the money illusion effect. Study 1 investigates the emotional attachment of the Polish to the dollar. Study 2 shows that the money illusion effect can be affected by this emotional attachment to currency. This seems to imply that the emotional attachment can cause an increase in the price evaluation by adding to the purchasing value of the currency an emotion-based value. This is in agreement with the accentuation theory. In Study 3 it was found that the money illusion effect is more prominent for higher absolute values of gains and losses than for smaller ones. This result can be explained in terms of prospect-theory value function.

Welfare Effects of the Euro Cash Changeover

Using merged data from the British Household Panel Survey (BHPS) and the German Socio-Economic Panel (SOEP), this paper applies a parametric difference-in-differences approach to assess the real effects of the introduction of the euro on subjective well-being. A complementary nonparametric approach is also used to analyze the impact of difficulties with the new currency on well-being. The results indicate a severe loss in well-being associated with the introduction of the new currency, with the predicted probability that a person is contented with his/her household income diminishing by 9.7 percentage points. We calculate a compensating income variation of approximately one-third. That is, an increase in postgovernment household income of more than 30% is needed to compensate for the rather drastic decline in well-being. The reasons for the negative impact are threefold. First, perceived inflation overestimates the real increase in prices resulting in suboptimal consumption decisions. Second, money illusion causes a false assessment of the budget constraint. Third, individuals have to bear the costs from the conversion and the adjustment to the new currency. Moreover, it is thought that losses are smaller when financial ability is higher. However, the impact of difficulties in using and converting the new currency is rather small, and the initial problems were overcome within one year of the introduction of euro cash.

Euro-Illusion: A Natural Experiment

We collect and analyse data on church collections to assess whether the introduction of Euro notes and coins had real effects on giving. Data for Italy suggests that money is not completely neutral while Irish data suggests a lower degree of money illusion. A smaller data set from continental Europe suggests different sorts of money illusion.

Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis*

Modigliani and Cohn [1979] hypothesize that the stock market suffers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors towards risk. Our empirical resuts support the hypothesis that the stock market suffers from money illusion.

Money Illusion and the Double Dividend in the Short Run

Abstract In their seminal paper, Bovenberg and de Mooij (1994) elucidate why an ecological tax reform will not yield a double dividend, i.e. fails to increase the efficiency of the tax system. The present paper slightly modifies the Bovenberg and de Mooij model by introducing money illusion. With this modification, an environmental tax reform that raises the price level may generate a double dividend, since the additional tax on the dirty good does not reduce labor supply. A prerequisite for the double dividend to occur is a sufficiently small elasticity of substitution between clean and dirty consumption. Moreover, accounting for money illusion always reduces the intertemporal gross cost of the tax reform.

Does Money Illusion Rescue the Double Dividend?

Discusses the introduction of money illusion to rescue the double dividend, based on labor supply. Expansion of the environmental tax reform rather than contract employment; Effects of value-added tax on nominal labor productivity and nominal wages; Enhancement of incentives to supply labor.

After the Death of Inflation: Will Fiscal Drag Survive?

Declining inflation rates might have negative consequences for tax revenues. Phenomena like the inflationary bracket creep in a progressive income tax system do not work any longer. With this background the paper analyzes the extent of fiscal drag for OECD countries since 1965. Some considerations on the role of money illusion and indexation in this context lay the theoretical base followed by a descriptive view on the relation between inflation, growth and tax revenues in the past decades. A framework is presented that allows for the classification of fiscal structures with regard to the type of fiscal drag. The subsequent econometric analysis is performed for total and disaggregated government revenues. The results reveal that an end of inflation would have a negative impact on tax revenues for a number of OECD countries. The results also back theoretical considerations on inflation's impact on different kinds of taxes: This impact tends to be positive for individual income taxes and social security contributions, it is neutral or negative for corporate income, property and indirect taxation. The paper concludes that both declining inflation and recent trends in tax reforms can be expected to limit the potential for future fiscal drag.

Money Illusion in the Stock Market: The Modigliani-Cohn Hypothesis

Modigliani and Cohn hypothesize that the stock market suffers from money illusion, discounting real cash flows at nominal discount rates. While previous research has focused on the pricing of the aggregate stock market relative to Treasury bills, the money-illusion hypothesis also has implications for the pricing of risky stocks relative to safe stocks. Simultaneously examining the pricing of Treasury bills, safe stocks, and risky stocks allows us to distinguish money illusion from any change in the attitudes of investors toward risk. Our empirical results support the hypothesis that the stock market suffers from money illusion.

Equilibrium Asset Prices and Investor Behavior in the Presence of Money Illusion: A Preference-Based Formulation

This article analyzes the implications of money illusion for investor behavior and asset prices in a securities market economy with inflationary fluctuations. Money illusion is modeled as an investor's partial overlooking the impact of inflation on the purchasing power of currency in his intertemporal decision making. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its utility 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 for relative risk aversion higher than unity. 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 and to a monetary economy with endogenous inflation.