News from the world of maths: The Illusion of Wealth

Thursday, August 30, 2007

The Illusion of Wealth

Imagine that one day you were greeted by your boss at work and told that you had been given a 100% pay rise because of your sterling efforts. Later that day, your bank calls to let you know that your savings and investments have doubled overnight due to an odd fluctuation in the international financial markets. But just when you thought that all your years of hard work had finally paid off, you discover when buying your groceries that evening that the price of food and drink has also doubled – but that does not matter too much, this is just a small increase.

Are you in a better position than you were the night before? Even taking into account the rise in your cost of living, your net savings have increased, so should you be thanking your boss and your bank manager?

Whilst you may feel wealthier in this situation, this is simply an illusion. You still have to work as many hours tomorrow as you did yesterday to buy your groceries – nominal values have risen, but not real values.

Economists have long considered that financial markets limit the impact of traders trading on nominal values – irrational traders. This is because it is assumed that they are taken advantage of by smarter traders. However, new studies by Jean-Robert Tyran of the University of Copenhagen have shown that there are situations in which money illusion can have a massive impact on the market, especially when there is a fall in nominal values.

An interesting example is the housing market. When interest rates are low, monthly nominal interest payments on mortgages are low compared to the rent on similar properties, so people start to buy. However, if inflation is decreasing, whilst current payments on the mortgage are falling, the real cost of future mortgage payments is increasing. This is because your salary is not growing and it will take you longer to pay off your debt. These investors have fallen for the illusion. They are similar to those who pay off their credit card bill with monthly payments over 24 months, instead of over 12, as the down-payments are smaller.

Tyran’s experimental studies show that if there is a monetary contraction within the market – that is, if the nominal costs of goods and services fall – firms are reluctant to follow suit and cut their prices as this would result in lower nominal profits, even if their real profit would remain the same.

This is called nominal loss aversion and results in part from the fact that our inbuilt fear of losses tends to outweigh our desire for a gain of the same amount. It can be seen in other financial areas, such as employees accepting a nominal pay increase, even if it results in a real pay-cut if it does not match inflation. Another example is a homeowner being more unwilling to sell a house at a real loss if it comes with a nominal loss rather than cloaked by a nominal gain.

Conversely, the experiments show that firms have no problem increasing their nominal prices should there be a rise in inflation and wages to maintain their real profit.

Laboratory work is often based on simplified economies, whilst interpretation of real data can be extremely difficult, so Tyran hopes that experimental research, combined with real observations of the market, can be used together to better understand money illusion.

posted by Plus @ 1:40 PM


At 9:59 AM, Blogger Tenon_Saw said...

When I click on the link to the blog from I am asked to log in although I can click 'cancel' and get here. IS that correct?

At 8:51 AM, Blogger westius said...

fixing it now
thanks for letting us know!