The findings in this paper suggest that money illusion is real in the sense that the level of reward-related brain activity in the vmPFC [ventromedial prefrontal cortex] in response to monetary prizes increases with nominal changes that have no consequence for subjects' real purchasing power.In the car just now, Ed and I were talking about the money illusion. Ed pointed out that no one thinks when you've just been given a 3% raise in an environment of 4% inflation, your pay has actually been cut. (I know ktm people would have no problem figuring this out--! But ktm people are not the norm.)
The medial prefrontal cortex exhibits money illusion Bernd Webera, Antonio Rangelb, Matthias Wibralc and Armin Falk - PNAS March 31, 2009 vol. 106 no. 13 5025–5028
I'm wondering whether good math education and/or the distribution of inflation calculators to one and all would affect the money illusion. I have no idea. Certain cognitive biases, loss aversion,* for instance, are apparently built-in, but -- the money illusion? Is there something built-in about the money illusion per se?
No time to think it through just now; for the moment I'm going to guess that the money illusion is a specific manifestation of something more fundamental. Which probably means good education and universal inflation calculators would help.
That said, we are stuck with the money illusion, at least for now.
So what does this mean?
I think it means that we need a certain level of inflation for the economy to work. Deflation is bad -- everyone seems to understand that -- but zero inflation is also bad. Inflation is like the porridge in Goldilocks and The Three Bears; it can be too hot, it can be too cold, or it can be just right.
What is just right?
Having spent as much time as I have reading the market monetarists (pdf file), I assume that just right means 2% inflation along with 3% real growth.*
But of course I don't know.
from the EurkAlert release:
"We had now confronted our test subjects with two different situations", Falk explains. "In the first, they could only earn a relatively small amount of money, but the items in the catalogue were also comparatively cheap. In the second scenario, the wage was 50 per cent higher, but now all the items were 50 per cent more expensive. Thus, in both scenarios the participants could afford exactly the same goods with the money they had earned – the true purchasing power had remained exactly the same." The test subjects were perfectly aware of this, too – not only did they know both catalogues, but they had been explicitly informed at the start that the true value of the money they earned would always remain the same.and more from the paper:
Despite this, an astonishing manifestation emerged: "In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario", declares Bernd Weber, focusing on the main result. "In this case, it was the so-called ventro-medial prefrontal cortex - the area which produces the sense of quasi elation associated with pleasurable experiences". Hence, on the one hand, the study confirmed that this money illusion really exists, and on the other, it revealed the cerebro-physiological processes involved.
We used fMRI to investigate whether the brain's reward circuitry exhibits money illusion. Subjects received prizes in 2 different experimental conditions that were identical in real economic terms, but differed in nominal terms. Thus, in the absence of money illusion there should be no differences in activation in reward-related brain areas. In contrast, we found that areas of the ventromedial prefrontal cortex (vmPFC), which have been previously associated with the processing of anticipatory and experienced rewards, and the valuation of goods, exhibited money illusion. We also found that the amount of money illusion exhibited by the vmPFC was correlated with the amount of money illusion exhibited in the evaluation of economic transactions.* And even loss aversion has "boundaries". (pdf file)
Intuitively, money illusion implies that an increase in income is valued positively, even when prices go up by the same amount, leaving real purchasing power unchanged (1). In this sense money illusion has been interpreted “as a bias in the assessment of the real value of economic transactions, induced by a nominal evaluation” (2). Economists have traditionally been skeptical about the notion of money illusion (3), but recent behavioral evidence has challenged this view (2, 4–6). For example, when asked to rate the happiness of 2 otherwise identical persons who received either a 2% wage increase without inflation or a 5% wage increase with 4% inflation, the majority of subjects attribute happiness on the basis of greater nominal raises, despite lower real raises (2).
Our main hypothesis was that areas of the brain that are engaged in the experiencing of rewards (7–9), such as the ventromedial prefrontal cortex (vmPFC), would exhibit money illusion in the sense of exhibiting a stronger BOLD response for incomes that were higher in nominal terms, but had an identical real value. Activity in these brain regions has been shown to be modulated by the receipt of both primary rewards such as food delivery (10) and more abstract forms of rewards like monetary incentives (9, 11, 12). Recent neuroimaging studies have also shown that the vmPFC is involved in the valuation of goods at the time of decision making (13–15).
The importance of this finding derives from the fact that the answer to many classic economic problems depends on whether money illusion exists. For example, money illusion has been put forward as an explanation for the nonneutrality of money, which implies that central banks can affect production, investment, and consumption through changes in monetary policy that have an impact on the inflation rate. Likewise it offers an explanation for the important phenomenon that wages and prices are often downwardly rigid, a leading explanation for involuntary unemployment (17, 18). It is also a potential cause of bubbles in important markets, such as the housing market (19), and of deviations of stock prices from their fundamental values (20, 21). At the firm level, money illusion is important to determine optimal wage policies, which depend much on whether workers care about nominal or real wages (22). Finally, the existence of money illusion is important for the understanding of the relation between income, inflation, and subjective well-being (23). Importantly, even small amounts of money illusion can have substantial effects....
* Because I'm married to a historian, I also assume that "just right" for our time would be not right for another time quite possibly.