In economics, money illusion is a cognitive bias where individuals think of money in terms of its nominal value rather than its real purchasing power. This misperception leads people to focus on the face value of money instead of considering how inflation affects its actual value over time. The term was popularized by economists such as Irving Fisher and John Maynard Keynes, and it highlights how individuals often fail to recognize the difference between nominal and real prices when making financial decisions.
For instance, if a person receives a 5% raise during a year when inflation is 3%, they might feel satisfied with their increase, not realizing that their real purchasing power has only increased by 2%.
To overcome money illusion, individuals can focus on calculating real values and consider how inflation affects their finances when evaluating pay raises or price changes.