CHAPTER 3

The Threat of inflation

■ Money illusion

A money illusion sounds like something a prestidigitator per-

forms by pulling $100 bills from a hat shown to be empty

moments before. In fact, money illusion is a longstanding

concept in economics that has enormous significance for you

if you’re a saver, investor or entrepreneur.

Money illusion is a trick, but it is not one performed on

stage. It is a ruse performed by central banks that can distort

the economy and destroy your wealth.

The money illusion is a tendency of individuals to confuse

real and nominal prices. It boils down to the fact that people

ignore inflation when deciding if they are better off. Examples

are everywhere.

Assume you are a building engineer working for a prop-

erty management company making $100,000 per year. You

get a 2% raise, so now you are making $102,000 per year.

Most people would say they are better off after the raise. But

if inflation is 3%, the $102,000 salary is worth only $98,940

in purchasing power relative to where you started.

You got a $2,000 raise in nominal terms but you suffered

a $1,060 pay cut in real terms. Most people would say you’re

better off because of the raise, but you’re actually worse off

because you’ve lost purchasing power. The difference between

your perception and reality is money illusion.