Lecture 2: Money Illusion
It is a fact of life that people often confuse nominal and real values in their everyday lives
because they are misled by the effects of inflation. For example, a worker might experience a 6
per cent rise in his money wages – giving the impression that he or she is better off in real terms.
However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.
Money illusion is most likely to occur when inflation is unanticipated, so that people’s
expectations of inflation turn out to be some distance from the correct level. When inflation is
fully anticipated there is much less risk of money illusion affecting both individual employees
The Main Costs of Inflation
What are the main costs of inflation? Why is the control of inflation given such a high priority in
macroeconomic policy-making? Supporters of tough inflation control would support the
arguments made in this quote in a speech delivered in 2002 from Mervyn King.
The case for maintaining price stability
‘It is clear that very high inflation – in extreme cases hyperinflation – can lead to a breakdown of
the economy. There is now a considerable body of evidence that inflation and output growth are
negatively correlated in high-inflation countries. For inflation rates in single figures, the impact
of inflation on growth is less clear.’
In explaining and assessing the costs of inflation, we must be careful to distinguish between
different degrees of inflation, since low and stable inflation is perceived to have less of a
damaging effect than hyper-inflation where prices are out of control. Another important part of
your evaluation is to be aware that inflation will have differing effects both on individuals and
also the performance of the economy as a whole.
Impact of Inflation on Savers:
Inflation leads to a rise in the general price level so that money loses its value. When inflation is
high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real
interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit
account, but if the annual rate of inflation