Money Illusion in the Twenty-First Century

Money Illusion in the Twenty-First Century

The starting point for any consideration of inflation is that wages (and interest, profits, and rents) are prices.  Every transaction has two sides, and one person’s price is another’s income.  In the aggregate, leaving aside international complications, inflation can’t have either a negative or positive effect on aggregate real income.  After this, you can explore issues of distribution, inflation’s effects on planning, and so on.

Money illusion is the name given to the failure to recognize the income-expenditure identity.  Your introductory economics textbook, if you were exposed in high school or college, defines the problem as one of recognizing changes in your nominal income but not the prices of the goods you buy.  It leads to the mistaken view that inflation makes you better off.

But people have gotten wise to price increases, if only because the media explode with concern when any potentially inflationary tremors are felt.  If anything, paranoia about inflation has become the norm.

This is also a form of money illusion, but a reverse of the first: people recognize the rise in prices but not that this also entails the rise in their incomes.  They rally in support of politicians who promise to reign in any hint of inflation, thinking that if prices stabilize they can fully enjoy the increase in their incomes, which they expect to continue unabated.  In my own, oddball textbook I call this “Type II Money Illusion”.

From a pure theory standpoint, these two forms of illusion have an identical basis, but one is railed against in every basic macroeconomics class while the other goes unmentioned.  Ever wonder why?