Money Illusion: Reconsidered in the Light of Cognitive Science

Abstract

A basic principle of economics is that people always prefer a larger set of opportunities. Money illusion can be considered as the phenomenon when people may not correctly perceive their budget constraints, and may act in ways that run counter to this preference. In this interpretation, money illusion is a cognitive bias, worthwhile to overcome. Herein I argue that taking a view of human decision-making based on certain strands of cognitive psychology, one can reinterpret the evidence for money illusion in two ways. First, I claim that money illusion is inescapable to some extent, and saying that we suffer from it is similar to alleging that we experience optical illusions, only because we are unable to see, say, individual atoms. Second, taking a view on “preferences” different from the traditional one, I contend that it may bring little benefit to get rid of money illusion even in the cases where it is possible to do so. To follow up the visual analogy, even if we can improve our eyesight it is not obviously desirable. These arguments seem to lead to a Candidean disposition: there is no possible improvement on the state of affairs as far as “money illusion” is concerned. Nonetheless, I will make some positive proposals concerning economic policy and economics research.

The Impact of Cognitive Skills on Investment Decisions: An Empirical Assessment and Policy Suggestions

“…Money illusion is also connected to other biases such as the fact that individuals are more worried to avoid losses than to receive gains (Akerlof, 2002). Money illusion therefore can damage consumers because they do not perceive it (Favaretto and Masciandaro, 2015) and make their choices using the wrong budget constraint (Vincze, 2019). Overall, money illusion has "significant consequences on financial choices and portfolio composition" (Darriet et al, 2020) especially during deflation.…”

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“…Another reason why deflation might be opposed is money illusion (Vincze 2019). 26 Money illusion is a long-known phenomenon.…”

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