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Funny Money

John Lim, 2:14 am ET

DO YOU SEE THINGS clearly when it comes to money? Here’s a test to find out. Which of the following scenarios would you prefer?

  • A 5% raise, but the inflation rate is 10%.
  • A 3% salary cut, but the inflation rate is 0%.

If you chose the 5% pay raise, you’ve fallen victim to a “money illusion.” This term describes our tendency to view money in nominal terms instead of inflation-adjusted “real” terms.

In the first scenario, you would have 5% more money to spend but you’d be able to buy 5% less in goods and services, thanks to the 10% inflation rate. In the second scenario, your nominal income would be down 3%—and that would also be your loss in purchasing power, because inflation was 0%.

Consider another hypothetical. Say you paid $200,000 in cash for a house 30 years ago. You sell the home for $500,000. Let’s ignore sales commissions, taxes and other expenses. Would you be happy with this investment?

On one hand, you would have made $300,000 on a nominal basis. But if you assume an annual inflation rate of 3%, your $200,000 home should be worth $485,452 after 30 years. On a real basis, you’d only come out $14,548 ahead on the sale. Had you invested the same $200,000 in the stock market, assuming a 7% annualized return, your investment would be worth $1.5 million after 30 years.

The money illusion stems from our view of the dollar as a fixed unit of measurement, like the inch or the mile. In reality, the dollar is a store of value that fluctuates. The value of a dollar in 1982 has shrunken to just 35 cents today. Put differently, a dollar today could only buy a third of the goods and services that it could have bought in 1982.

The money illusion is tricky because we see nominal prices with our eyes. Inflation, by contrast, is sometimes a stealth phenomenon. We might pay the same price for our favorite box of cookies without realizing that there are fewer cookies in the package. We may notice a recent surge in gas prices, but would we notice if the price of chicken rises a few cents per pound next month?

A more recent example of the money illusion comes from the yield on Series I savings bonds. Investors appear gleeful knowing that they can earn an annualized 9.6% yield on I bonds over the next six months. But that’s just the nominal return. The real return—the return after subtracting out inflation—is designed to be zero. Still excited? I am, but only because other fixed income options are lagging inflation.

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Steve Spinella
Steve Spinella
16 days ago

My friend, the accounting professor, says that inflation refers to changes in the value of currencing, but appreciation refers to changes in the value of things. I scratch my head, and wonder why we talk about one store of value as different than another. If It takes 10% of a certain house to buy a certain car, does it matter how many dollars the swap involves? While harder to calculate isn’t the same logic underway in the swap of IBM stock for loaves of bread and packages of chicken breasts?
Is the only time that the value of money itself matters the time we have it sitting unused in our pockets and under our mattresses?

Philip Stein
Philip Stein
17 days ago

Maybe the money illusion will cause some people to be too lackadaisical about higher inflation.

To appreciate the damage that prolonged inflation can do to our economy, may I suggest “The Great Inflation and its Aftermath” by Robert Samuelson. The paperback version was published in 2010.

The book describes how the inflationary 1960s and 70s “transformed American politics, economy, and everyday life.” Consider the book a wake-up call if the Fed vacillates in its commitment to end this inflationary spiral.

David Petersen
David Petersen
19 days ago

I understand the purpose of your post however, I have to have someplace to live. Ignoring that fact is a bit of living in a vacuum. 10 percent inflation does not hit all sectors the same. It isn’t too hard to come up with an example where a 5% raise is a better option based on my own spending patterns. With that said, you are right we, as human beings, don’t understand percents and underestimate the power of compounding.

Joe Kiefer
Joe Kiefer
19 days ago

Here is a another element of the pay-raise vs. inflation-rate comparison: https://ofdollarsanddata.com/youve-been-thinking-about-inflation-all-wrong/

johntlim
johntlim
19 days ago
Reply to  Joe Kiefer

The blog article you reference is specious. The suggestions that savers are somehow less affected by inflation is only true in the short run. Their savings are devalued by inflation just as much as the dollars they spend. It’s just that the “day of reckoning” is delayed.

Mik Cajon
Mik Cajon
19 days ago

Nailed it…again.

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