Houdini among finance - what is the money illusion?

Contemporary people cannot imagine functioning without money - a means of payment used in everyday life. It would seem that a thick wallet and a multi-digit amount on the account should provide security and peace of mind. However, if you think that the number of banknotes in your wallet is having a bearing on your wealth, you may be under the money illusion.

Money Illusion - What is it?

The phenomenon of money illusion can be observed every day. An example is the labels in clothing stores - you glance at the cardboard box and you are pleased to find that the selected pants cost only 20. But 20 what? When it turns out that the euro, the spell is broken - converted into zlotys, the price of the clothes will be in the range of PLN 100.

Another example is the wage increases given to workers when inflation is also rising. The employee will be happy to hear that his salary will increase by 10% from next month. Nothing wrong with that until it turns out that inflation next month also increased - by 12%. Thus, in practice, the value of the salary received by an employee fell by 2%.

When we highlight all the factors that determine the actual condition of our property, it seems that a rational and responsible person should take all of them into account. This opinion was shared by many specialists, incl. Milton Friedman, a world-renowned economist and Nobel laureate. In his opinion, the phenomenon of money illusion cannot exist precisely because man is a rational being.

On the other hand, the facts and research of other scientists, unfortunately, contradict Friedman's theory. It turns out that it is quite common to spend more abroad, in a country with a stronger currency. The human mind is usually guided by the "cognitive miser" technique - it wants to obtain the necessary information about the environment as quickly as possible and at the lowest possible cost. So when you know that in your country a book costs PLN 50, and in England you see it for PLN 8, it seems to be an incomparable difference. And although most people know perfectly well that the value is almost identical, they still fall into the trap of a lower price tag.

When is face value more important than real value?

The adage of cautioning against judging a book by its cover will also work in the case of the money illusion. The examples described above clearly show that people often value the face value of money more than its real value. When we look at the banknotes and see the number 100 on one of them and the number 20 on the other, the first thought is to give more value to the former.

A similar mechanism arises not only in currency conversions, but also in other situations, e.g. with loans. Most often, when deciding to repay a debt in installments, we have a choice of larger installments, which we will pay off in a shorter time, or lower installments, but spread over a longer period. Most people lean more towards the latter option, perceiving the lower monthly outflow from the account as a greater saving. In practice, however, it turns out that by choosing a longer repayment date, we will pay more - the interest charged for subsequent installments will be higher in total than those added to higher installments, but regulated in a shorter time.

How to fight the money illusion?

Since the money illusion is very often an unconscious act, it seems that it will be hard to fight against. In practice, however, you only need a bit of common sense and a reliable calculation.

Therefore, it is worth knowing the average exchange rate in advance when you go abroad or in another situation, when deciding to buy in a foreign currency. It doesn't have to be exact to the penny. When deciding on a loan, it is good to accurately calculate the interest in the analyzed repayment variants. Such actions can save us from unnecessary overpaying, which is caused by the banal laziness of the human brain.