Money illusion is a strong bias that we are all confronted with every day. Even if you’re not investing money in the stock market, you can suffer from money illusion. Money illusion, or price illusion, argues that we tend to interpret prices and monetary amounts in nominal terms, instead of real terms. As such, we confuse the face value of money with its purchasing power.
This distinction is important, as a particular amount of money many years ago is not worth the same amount today. The main reason why this is the case, is because of the effect of inflation (i.e. increases in the Consumer Price Index (CPI) over time).
Example of money illusion
Let’s consider an example from finance. Suppose you’ve invested a certain amount of money in a stock, say a 1000. After one year, the stock price increased by 4% and your stock is now worth 1040. You decide to sell and the 1040 is deposited on your current account. Since the amount of money you own has increased, you will probably feel richer. However, over the same period of time, the rate of inflation was 5%. This means that a 1040 today will not allow you to buy the same amount of goods when you initially purchased the stock. In fact, in real terms 1040 is only worth 990
For more information on how to discount cash flows, see the part on discounting cash flows. The increased nominal amount of money creates the illusion that you have become wealthier.
We learn from this that it is important that, before interpreting prices and monetary amounts, we should always make sure we are interpreting them in real terms. A large amount of money, in notional terms, might not allow you to purchase a lot of goods and services.
If we want to avoid suffering from money illusion, we should first convert money amounts from nominal to real terms.