Many forget inflation and fall prey to the money illusion

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There’s an effect called the money illusion, where people forget that there is such a thing as inflation. Image from Wikimedia Commons.

There is a phenomenon in economics called the “money illusion,” which a lot of people are blinded to. It’s basically a rookie mistake, because anyone who has ever taken even a high school level economics course knows how to counter it, which is to adjust for inflation.

Even top notch reporters snookered by money illusion

Columnist Erik Sherman recently wrote an article on CBS Moneywatch, excoriating some of his colleagues in the business press for an error in covering the stock price and total value of the Apple corporation.

Anyone who reads much business news knows the business press and tech press fawn on Apple. They seem to compete to see who can be the most obsequious and it has gotten, frankly, disgusting. However, in their sycophancy, they made a rookie mistake. Outlets reported that Apple is the most valuable company of all time by dollar amount but did not adjust for inflation. Apple is actually second to Microsoft in the 1990s.

It’s a schoolboy error and also an economic phenomenon known as the “money illusion.”

Real versus nominal

The term “money illusion,” as Sherman points out, was coined in 1928 by legendary economist Irving Fisher. It has to do with the effects of inflation. The illusion is where people confuse a number of dollars with the value, or amount of goods and services it can buy, it represents.

Inflation is where more units of currency enter the money supply of a given nation and prices go up over time, as each unit of currency loses value in terms of how much stuff each unit can buy. Whenever there is more of something, the value of it goes down because it’s more common.

The effect of inflation is that the number of dollars a thing is worth, or the nominal value, may increase, but the real value it represents, the amount of goods and services that amount buys, also called purchasing power, declines. When a person think a number of dollars in one period is the same as another, that’s the money illusion.

Old timers, real estate and gold bugs all subject

Ever hear someone say “back in my day, you got a loaf of bread for two pennies and for a full day’s work you only got two bits,” or “housing values go up over time” as a justification for buying a house? That’s the money illusion at work. One dollar in 1934 is not one dollar in 2012; according to the Bureau of Labor Statistics’ inflation calculator, it’s $17.10, an increase of more than 1,700 percent.

Gold is another example. According to CNN, gold hit it’s record spot price in Sept. 2011 at $1,920 per ounce. However, according to Bloomberg article, the peak for gold came in 1980, when it hit $873 per ounce. In today’s dollars, that’s $2,287.

Sources

CBS

CNN

Bloomberg

BLS Inflation Calculator: http://www.bls.gov/data/inflation_calculator.htm

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