Money Illusion

So, what is money illusion, one may ask. It is the illusion (or say delusion) that your money is growing, or your pay has been raised when it is not.

Suppose, someone receives an annual pay raise of 6% and he is super happy for getting the pay raise because he is considering the nominal wage growth as his real wage growth. Nominal wage growth refers to the inflation-unadjusted wage growth. So, if inflation for that year is 7%, then actually it is a 1% pay cut, because due to the rise of inflation by 7%, the purchasing power of money diminishes and therefore, if the rate of inflation is more than the rate of pay raise, then it is a loss and not a win.

However, while considering the gain in earnings or gain in money, most of the people assume nominal or face value as the real growth and keep inflation out of consideration. So, they stay under the money illusion that they have experienced a growth in money, ignoring the effect of inflation on the purchasing power of that money.