Definition of Monetary Illusion

The monetary illusion is an effect produced when an agent is guided by nominal variables instead of using real variables. An individual may have a monetary illusion when he perceives the nominal increase in his income but not the increase in prices, being able to think that he is in a better situation, but without actually being so. A situation where there is inflation is the best way to look at this.

If prices in an economy have risen more than nominal income of personsIn real terms, people have become impoverished. This means that consumers have lost purchasing power and it has caused them to make undesirable or incorrect decisions regarding consumption, savings or investment. On the other hand, the expectations that are had about the evolution of the market can also affect the increase of the monetary illusion.

An example of monetary illusion

As we have indicated, the most normal thing is that the monetary illusion occurs when we are talking about wages in times of inflation. To see the difference that can be reached, we will see it through an example:

A worker earns € 1000 per month. If you increase your salary by 15%, your salary becomes € 1150. The worker's salary will be improved, but nothing is further from the truth: if there is inflation above that 15% of the salary increase, the consumer will have less purchasing power before its increase. That is to say, it happens the opposite of what can be imagined: the consumer loses and, worst of all, it leads him to carry out worse consumption, saving and investment actions.

That is why you have to be very careful with this effect, as it seems to be beneficial but the reality is quite different, as is the case with other harmful effects in the economía for the consumers.

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