Forum for Science, Industry and Business

Sponsored by:     3M 
Search our Site:

 

Money illusion and the market

24.08.2007
Standard economics assumes that people base their decisions on real value only and take changes in price tags properly into account. For example, a rational consumer is assumed to base his shopping decisions on “real” prices (e.g., how many hours do I have to work for a loaf of bread?) and would not change his consumption patterns if all “nominal” prices were to move in proportion (e.g. are inflated by the same factor). Yet, normal people are often confused by purely nominal changes.

To illustrate, compare a situation in which money wages increase 2.3% and prices increase 3.1% over one year with a situation in which money wages fall by 0.8% at constant prices. The two situations are equivalent in “real terms”, i.e. if inflation is taken properly into account. People who perceive these situations differently are said to be prone to money illusion.

Economists have only begun to understand when money illusion affects market outcomes. It was commonly thought that the impact of irrational behaviour is limited in markets because “smart agents” can take advantage of irrational traders. However, recent evidence from the field and the experimental laboratory suggests that money illusion can affect markets.

Effects on the housing market

A striking example comes from the housing market. Housing prices have risen sharply in several countries, and booms followed by busts are common in housing markets. Money illusion in the guise of a confusion of nominal and real interest rates may be partly to blame. When inflation is low, monthly nominal interest payments on mortgages are low compared to the rent of a similar house. Housing prices therefore seem cheap, causing illusion-prone buyers to buy rather than rent which, in turn, causes an upward pressure on housing prices when inflation declines. However, decreasing inflation also increases the real cost of future mortgage payments. Investors who base their decision on the salient low nominal mortgage payments but ignore the less visible effect of inflation on the future real mortgage cost are prone to an illusion.

Experimental evidence

Economists have remained sceptical because field evidence consistent with money illusion may also be consistent with alternative accounts, involving fully rational agents. Such alternative accounts can convincingly be ruled out in the laboratory. Experimental studies complement field studies by investigating simpler markets but under more controlled conditions, allowing researchers to isolate the effect of money illusion.

Experiments conducted by Ernst Fehr (University of Zurich) and Jean-Robert Tyran (University of Copenhagen) show that money illusion can have a profound impact on market prices. In the experiments, decision makers are presented with either real or nominal information on profits under otherwise identical conditions to test the effect of inflating or deflating all nominal values. The authors find that firms are reluctant to cut nominal prices with deflation in an attempt to avoid lower nominal profits associated with lower price levels, but are much less reluctant to increase nominal prices with inflation. The studies also show that money illusion has stronger effects on market prices when rational agents have incentives to “follow the crowd” rather than to “go against the tide”, i.e. when they compensate the choices of those prone to money illusion.

Jean-Robert Tyran | alfa
Further information:
http://www.ku.dk

More articles from Business and Finance:

nachricht Mathematical confirmation: Rewiring financial networks reduces systemic risk
22.06.2017 | International Institute for Applied Systems Analysis (IIASA)

nachricht Frugal Innovations: when less is more
19.04.2017 | Fraunhofer-Institut für Arbeitswirtschaft und Organisation IAO

All articles from Business and Finance >>>

The most recent press releases about innovation >>>

Die letzten 5 Focus-News des innovations-reports im Überblick:

Im Focus: Fizzy soda water could be key to clean manufacture of flat wonder material: Graphene

Whether you call it effervescent, fizzy, or sparkling, carbonated water is making a comeback as a beverage. Aside from quenching thirst, researchers at the University of Illinois at Urbana-Champaign have discovered a new use for these "bubbly" concoctions that will have major impact on the manufacturer of the world's thinnest, flattest, and one most useful materials -- graphene.

As graphene's popularity grows as an advanced "wonder" material, the speed and quality at which it can be manufactured will be paramount. With that in mind,...

Im Focus: Exotic quantum states made from light: Physicists create optical “wells” for a super-photon

Physicists at the University of Bonn have managed to create optical hollows and more complex patterns into which the light of a Bose-Einstein condensate flows. The creation of such highly low-loss structures for light is a prerequisite for complex light circuits, such as for quantum information processing for a new generation of computers. The researchers are now presenting their results in the journal Nature Photonics.

Light particles (photons) occur as tiny, indivisible portions. Many thousands of these light portions can be merged to form a single super-photon if they are...

Im Focus: Circular RNA linked to brain function

For the first time, scientists have shown that circular RNA is linked to brain function. When a RNA molecule called Cdr1as was deleted from the genome of mice, the animals had problems filtering out unnecessary information – like patients suffering from neuropsychiatric disorders.

While hundreds of circular RNAs (circRNAs) are abundant in mammalian brains, one big question has remained unanswered: What are they actually good for? In the...

Im Focus: RAVAN CubeSat measures Earth's outgoing energy

An experimental small satellite has successfully collected and delivered data on a key measurement for predicting changes in Earth's climate.

The Radiometer Assessment using Vertically Aligned Nanotubes (RAVAN) CubeSat was launched into low-Earth orbit on Nov. 11, 2016, in order to test new...

Im Focus: Scientists shine new light on the “other high temperature superconductor”

A study led by scientists of the Max Planck Institute for the Structure and Dynamics of Matter (MPSD) at the Center for Free-Electron Laser Science in Hamburg presents evidence of the coexistence of superconductivity and “charge-density-waves” in compounds of the poorly-studied family of bismuthates. This observation opens up new perspectives for a deeper understanding of the phenomenon of high-temperature superconductivity, a topic which is at the core of condensed matter research since more than 30 years. The paper by Nicoletti et al has been published in the PNAS.

Since the beginning of the 20th century, superconductivity had been observed in some metals at temperatures only a few degrees above the absolute zero (minus...

All Focus news of the innovation-report >>>

Anzeige

Anzeige

Event News

Call for Papers – ICNFT 2018, 5th International Conference on New Forming Technology

16.08.2017 | Event News

Sustainability is the business model of tomorrow

04.08.2017 | Event News

Clash of Realities 2017: Registration now open. International Conference at TH Köln

26.07.2017 | Event News

 
Latest News

A Map of the Cell’s Power Station

18.08.2017 | Life Sciences

Engineering team images tiny quasicrystals as they form

18.08.2017 | Physics and Astronomy

Researchers printed graphene-like materials with inkjet

18.08.2017 | Materials Sciences

VideoLinks
B2B-VideoLinks
More VideoLinks >>>