The tendency to think in terms of nominal value of money, without taking adequate account of changes in its actual value is the basis of the phenomenon known as Money Illusion (MI). The concept of MI was analysed in detail for the first time by I. Fisher (1927)¹ in "Money illusion". In particular, some definitions are proposed in relation to the phenomenon of MI in literature; the field of psychology and its relationship with economics has been investigated, and the empirical evidence of the effects of this phenomenon in various markets, such as the stock and the real estate ones, has been summarised. The definition given by Fisher (1928) of the MI phenomenon refers to the currency as unit of measure: "money illusion or inflation illusion as the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value"². Patinkin (1965)³ defines, in general, MI as "any deviation from decision making in purely real terms."
In a perfect world, the currency plays the role of a "veil", as in decision-making contexts "rational" has meaning only with relative values. If, for example, prices and wages double, in the perfect world, the agents' rational decisions are the same, because the real value of the currency is unchanged. However, many psychological biases may undermine a perfect vision through this "veil".
In this context, the studies undertaken by the Keynesian economists who include the MI phenomenon among the causes of non-neutrality of money⁴ are to be considered. To observe neutrality of money in the long term, MI must be absent. MI was seen as an irrational and "costly" components by economic agents, and therefore, not plausible.
Recently, following the boom in property values, which occurred in a context of relatively low inflation, and the subsequent increase in inflation rates across the euro area from 2007 to present days - which has coincided with a "deflate" of the real estate bubble - a growing interest in the study of empirical and theoretical implications of the phenomenon of MI has been experienced.
Among the empirical studies, it is worth referring to the survey conducted by Shafir, Diamond and Tverky (1997)⁵ and the experiment of Fehr and Tyran (2001, 2007)⁶; while in relation to the theoretical approaches, the works of Brunnermeier and Julliard (2007)⁷, Genesove and Mayer (2001)⁸, Piazzesi and Schneider (2007)⁹ relating to the property market, and the work of Campbell and Vuolteenaho (2004)¹⁰, Cohen, Polk and Vuolteenaho (2005)¹¹ for the stock market are of particular relevance.
In particular, the work of Shafir, Diamond and Tverky (1997) shows how the preferences of agents depend in large measure on how the problem is proposed: in real terms or in nominal terms. For example, if the problem is placed in nominal terms, it has been noted that agents prefer the "nominally" less risky than the alternative which is the least risky in real terms. In general, officers are more averse to the nominal risk rather than to the real one. This also shows how the degree of MI is unexpectedly high in the analysed sample and this may be the consequence of the greater salience of nominal than real, which leads to greater consideration in decision-making processes of these instead of actual variables. The result drawn from the submission of a large number of surveys from categories of people different one from the other (students, vendors, passengers on aircraft, undergone in different contexts) has demonstrated strong evidence of the existence of this phenomenon. The conclusion of the authors was to define the phenomenon of MI as a widespread and persistent phenomenon among economic and non-economic agents.
There are many possible psychological biases that have the effect of confusing economic agents in their decisions, when taken by looking through the veil of money. The framing effect is one of the most important biases. Alternative representations of the same problem (framing) can result in substantially different decisions by the same agents (Tversky and Kahneman (1981)¹². A special form of framing effect, significant in the context of the real estate market, is the so-called "anchoring effect". Specifically, it refers to a particular form of framing effect, showing how, in many situations, people make estimates on the value of an asset from a given initial value. The initial value, or starting point, may be suggested by the formulation of the problem or may be the result of a calculation. Genesove and Mayer (2001) have documented how investors are reluctant to realise nominal losses, particularly with regard to the context of the real estate market, as people are reluctant to sell a house at a price lower than that paid for buying.
By investigating the labour market, Shiller (1997)¹³ documents - in this case through a survey - how interviewed people consider that nominal wages and inflation have the same behaviour in the long run, by saying that fewer than one third of people who have undergone the survey consider that the nominal wages have a positive process when the rate of inflation increases over the years. Moreover, statistics show a positive correlation in the long term between inflation and wages, and therefore the impact of inflation on wages is considered an indirect effect.
This inattention to indirect effects may be related to a particular form of psychological judgment bias: mental accounting¹⁴. The so-called "Mental accounting" - as defined by Thaler (1980)¹⁵ - is "a close cousin of narrow framing and refers to the phenomenon that people keep track of gains and losses in different mental accounts."
Fehr and Tyran (2001) have studied the implication of MI in relation to the stickiness of prices, by conducting multiple experiments from a price-setting game in order to isolate the effects of other potential determinants of price stickiness. From the analysis of these experiments it is shown as negative changes in money are the cause of considerable reductions in the output, when the payoffs are denominated in nominal rather than in real terms. As the authors conclude, the economic agents "act as if other price setters suffered from money illusion, making them, in turn, reluctant to cut prices", and the reaction of prices to changes in money supply leads to the formation of expectations concerning "the response of other price setters to the same shock." The results of the experiments of Fehr and Tyran (2001) show that the indirect effect of money illusion is of absolute importance in a strategic context. It also shows that the aggregate effect can be substantial, although only a minority of economic agents suffer from money illusion.
In recent years, there has been a growing interest in studying this context. In the paper "Money illusion and housing frenzies", economists Brunnermeier and Julliard studied the relationship between real estate values and inflation, by composing the price-rent ratio and by identifying a suitable proxy for the mispricing in the real estate market. Using data from the British housing market, they show that market trends are largely explained by variations in the inflation. In particular, a reduction in inflation may generate the effect of an increase in the price of real estate in an environment where economic agents are prone to money illusion.
Numerous studies have documented a negative correlation between nominal yields and inflation [Fama and Schwert (1977); Gültekin (1983)]. As stated by Modigliani and Cohn (1979), the assessment made by money-illusioned economic agents of different assets is inversely proportional to the level of inflation in the economy. In particular, Modigliani and Cohn (1979) assumes that the valuations of the assets differ from their fundamental values because of two inflation-induced errors in judgment: the tendency to capitalise equity earnings at the nominal rate instead of at the real rate, and the inability to understand that, over time, the debts will devalue in real terms. In practice, stock prices are undervalued (overvalued) during periods of high (low) inflation. Recently, some studies have provided empirical support to the so-called Modigliani-Cohn hypothesis, including Campbell and Vuolteenaho (2004).
While it is not possible to give an answer to the existence or not of MI and the definition of the rate of diffusion in a given economic context, the impact on the economy arising from the effects of money illusion are indisputable, as clearly as many relevant decisions taken by economic agents strongly depend on the capacity / ability to distinguish between nominal and real values. Although many of the works carried out to date have been proposed by theoretical models of the phenomenon with respect to the evaluations of various assets, the effects of MI on the investor welfare were never considered. An attempt is reflected in the study conducted by Miaoy Jianjun and Danyang Xiez (2007)¹⁶ where the authors have shown that MI has the effect of reducing economic growth in the country and that consequently leads to a welfare cost¹⁷ through the influence of the phenomenon on the choices of consumption and savings. They suggest that an ex-ante definition of the rate of growth in money supply can be effective to eliminate the cost determined by the money illusion phenomenon. Ultimately, although in general, monetary policy has the objective to maximize the utility of individuals. The two scientists conclude their work with a call on the authorities of monetary policy to consider a utility function that takes into account the degree of MI in a given economy.
-----------------------------------------------------
¹ Fisher I. (1927) "Money illusion" Adelphi, New York.
² Numerous scholars use the expressions money illusion and inflation illusion as synonyms
³ Patinkin D. (1965) "Money, interest and prices", Harper and Row, New York.
⁴ According to the theories of Keynesian economists ((Keynes (1936), Leontief (1936)), workers suffer from money illusion. The labour supply is a function of nominal wages and labour demand is a function of real wages. Such a difference is the effect of dependency on the part of workers on money illusion, while employers are believed to be exempt from such bias (also an increase in wages resulting from renewals of agreements with trade unions are perceived by employees as a premium for their skills and/or as a reduction in the percentage of profits taken from employers and a corresponding increase in the percentage in their favor; this type of thinking is behind the bias that underlies the function of labour demand arising from failure to consider the role of inflation in the economic process).
⁵ Shafir E., Diamond P., Tversky A. (1997) "Money illusion" Quarterly Journal of Economics.
⁶ Fehr E., Tyran J. R. (2001) "Does money illusion matter?" American Economic Review
⁷ Brunnermeier M. K., Juillard C. (2007) "Money illusion and Housing Frenzies". Review of Financial Studies.
⁸ Genesove D., Mayer C. (2001) "Loss aversion and seller behavior: evidence from the housing market". Quarterly Journal of Economics.
⁹ Piazzesi M., Schneider M. (2007) "Inflation illusion, credit and asset prices". Asset Prices and Monetary Policy.
¹⁰ Campbell J., Vuolteenaho T. (2004) "Inflation illusion and Stock Prices". American Economic Review Papers and Proceedings.
¹¹ Cohen R., Polk C., Vuolteenaho T. (2005) "Money illusion n the stock market: the Modigliani-Cohn hypothesis". Quarterly Journal of Economics.
¹² Tversky A., Kahneman D. (1981) "The framing of decisions and the Psychology of choice" Science.
¹³ Shiller R. J. (1997) "Public resistance to indexation: a Puzzle" Brooking Papers on Economic Activity.
¹⁴ Mental accounting refers in general to the trend experienced by people to mentally distinguish money into "separate" accounts based on a variety of subjective criteria, such as the source of money and the associated objectives.
¹⁵ Thaler J. (1972) "Toward a positive theory of consumer choice", Journal of Economic Behavior and Organization.
¹⁶ "Monetary Policy and Economic Growth under Money Illusion". Working Paper Boston University & Hong Kong University.
¹⁷ The welfare cost is defined as: Δ (θ, π), hence resulting into a function of the money illusion coefficient and of the expected inflation rate.

Bibliography
FISHER I. (1927) "Money illusion", Adelphi, New York.
PATINKIN D. (1965) "Money, interest and prices", Harper and Row, New York.
SHAFIR  E., DIAMOND  P. and TVERSKY A. (1997) "Money illusion", Quarterly Journal of Economics.
FEHR E. and TYRAN  J. R. (2001) "Does money illusion matter?", American Economic Review.
BRUNNERMEIER  M. K. and JUILLARD  C. (2007) "Money illusion and Housing Frenzies", Review of Financial Studies.
GENESOVE  D. and MAYER C. (2001) "Loss aversion and seller behavior: evidence from the housing market", Quarterly Journal of Economics.
PIAZZESI  M. and SCHNEIDER  M. (2007) "Inflation illusion, credit and asset prices", Asset Prices and Monetary Policy.
CAMPBELL  J. and VUOLTEENAHO  T. (2004) "Inflation illusion and Stock Prices", American Economic Review Papers and Proceedings.
COHEN R., POLK  C., VUOLTEENAHO  T. (2005) "Money illusion in the stock market: the Modigliani-Cohn hypothesis", Quarterly Journal of Economics.
TVERSKY  A. and  KAHNEMAN  D. (1981) "The framing of decisions and the Psychology of choice", Science.
SHILLER  R. J. (1997) "Public resistance to indexation: a Puzzle", Brooking Papers on Economic Activity.
THALER  J. (1972) "Toward a positive theory of consumer choice", Journal of Economic Behavior and Organization.
MIAOY J. and XIEZ D.(2007) "Monetary Policy and Economic Growth under Money Illusion", Working Paper Boston University & Hong Kong University.

Editor: Alberto Maria SORRENTINO
© 2009 ASSONEBB