2011 reprint of 1928 edition. In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. This is a fallacy as modern fiat currencies have no inherent value and their real value is derived from their ability to be exchanged for goods and used for payment of taxes. The term was coined by John Maynard Keynes in the early twentieth century, and Irving Fisher 1928 book, The Money Illusion, is one of the most important works on the subject.
In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is false, as modern fiat currencies have no intrinsic value and their real value is derived from their ability to be exchanged for good sand used for payment of taxes.
The term was coined by John Maynard Keynes in the early twentieth century, and Irving Fisher wrote an important book on the subject, The Money Illusion, in 1928. The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. Shafir, Diamond and Tversky (1997) have provided compelling empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real world situations.
Shafir et al. also state that money illusion influences economic behaviour in three main ways:
Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.
Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.
Fisher made important contributions to utility theory and general equilibrium. His work on the quantity theory of money inaugurated the school of economic thought known as "monetarism." Both Milton Friedman and James Tobin called Fisher "the greatest economist the United States has ever produced." Some concepts named after Fisher include the Fisher equation, the Fisher hypothesis, the international Fisher effect, and the Fisher separation theorem.
Fisher was perhaps the first celebrity economist, but his reputation during his lifetime was irreparably harmed by his public statements, just prior to the Wall Street Crash of 1929, claiming that the stock market had reached "a permanently high plateau." His subsequent theory of debt deflation as an explanation of the Great Depression was largely ignored in favor of the work of John Maynard Keynes.His reputation has since recovered in neoclassical economics, particularly after his work was revived in the late 1950s and more widely due to an increased interest in debt deflation in the Late-2000s recession.
Fisher produced various inventions during his lifetime, the most notable of which was an "index visible filing system" which he patented in 1913 and sold to Kardex Rand (later Remington Rand) in 1925. This, and his subsequent stock investments, made him a wealthy man until his personal finances were badly hit by the Crash of 1929.