Money illusion is an economic theory stating that people tend to view their wealth and income in nominal dollar terms rather than in real terms.
In other words, it is assumed that people do not consider the level of inflation in an economy, wrongly believing that a dollar is worth the same as it was the prior year. It is also sometimes referred to as a price illusion.
The term money illusion was first coined by American economist Irving Fisher in his book “Stabilizing the Dollar.” Fisher later wrote an entire book dedicated to the topic in 1928, titled “The Money Illusion.”
Fisher’s book detailed a German shopkeeper during a time when Germany’s currency (The German mark at the time, not the euro) was undergoing massive devaluation due to hyperinflation. A hyperinflation is an event where there is very high & accelerating inflation – Germany experienced one after World War 1.
The shopkeeper was under the belief that because she was selling shirts above the cost she acquired them for, she was making a profit. However, according to Fisher, the shopkeeper lost money, from selling her shirts. It is because the shopkeeper had lost purchasing power, or the number of goods and services she could purchase with the same amount of money, due to inflationary pressures.
The Problem of Inflation
Inflation, and the fight against it, has been very much in the public’s mind in recent years. The shrinkage in the purchasing power of the dollar in the past, and particularly the fear (or hope by speculators) of a serious further decline in the future, has greatly influenced the thinking of Wall Street.
Whilst there have been efforts to decentralize aspects of decision-making in the past, nothing has been as profound as the decentralizing of money. During an important period in our history, gold was the de-facto global reserve and the underlying asset that gave us trust in sovereign currency or paper money. The 1971 US government under President Richard Nixon “unpegged” the US Dollar from gold, effectively bringing the gold standard to an end. Various political and economic events before and after that pivotal decision left the US Dollar the new global reserve currency, albeit backed by nothing but trust.
The Federal Reserve, freed from the constraints of pegging their “paper” to gold, has been constantly expanding the money supply under various pretexts. However, it is an indisputable fact that virtually all fiat currencies, including the dollar, have lost anywhere between 50-100% of their value over the last few decades. Little is spoken of enduring inflation and permanent loss of “purchasing power” becoming a mainstay in our modern economic system.