Monday, November 8, 2021

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?


Anonymous said...

Inflation affects everyone, although in different degree depending on the consumption pattern. However, income increase tends to concentrate on the top percentile. The benefits of inflation, that is, the resulting higher income, are not equitably distributed among the households. But the costs of inflation tends to be more equally shared.

mgkurilla said...

The benefits of inflation are more than simply higher incomes. Inflation will also make debt more manageable in terms of servicing that debt due to higher incomes. The real problem with inflation is that it is not typically evenly distributed across the economy and this produces issues of under and over supply in different sectors which changes the distribution of economic activity. Economists are largely unimaginative and mostly extrapolate past trends, so any disruption in the previous pattern of economic activity makes their forecasts look bad. Politicians like a bit of inflation as it makes public debt more manageable. Finally, it's not inflation per se that is the issue, but rather the inflation rate relative to the overall economic growth rate. If the later is greater than inflation is fine and under control. At the same time, the growth rate needs to exceed the population growth rate or else the standard of living will decline.