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Money illusion – comparing apples with apples

Too many people confuse face value with purchasing power

Ed Ou/Associated Press

It is idiotic to report that Apple Inc. is now the biggest company in history by market capitalization. At $850-billion (U.S.), dotcom-era Microsoft remains the record holder in today's money. But those ignoring the effect of inflation are unwittingly at the centre of a long-running academic debate with contemporary implications for how monetary policy could help create jobs. That debate is over what economists call money illusion.

Money illusion as defined by Irving Fisher in 1928 is when people think of money in nominal rather than real terms. That is, mistaking the face value of something (Apple's market cap) with purchasing power (what Apple's market cap could actually buy). Money illusion was used to explain why nominal wages could be sticky: why workers might be happy to accept a 2-per-cent wage increase even though inflation is running at 4 per cent.

Money illusion also underpinned the early Phillips Curve, a theory that suggested policy makers face a trade-off between inflation and unemployment. (Companies hire more in times of inflation because workers do not realize they are becoming cheaper in real terms.) But then Milton Friedman came along and said the idea was hogwash. Of course the supply of labour depends on real wages – employees adapt to inflation. The concept of money illusion was abandoned, as was the idea that long-run unemployment might be reduced via inflation.

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A few decades later money illusion began a revival. Behavioural economists showed that people really do get confused about numbers in all kinds of ways. Further studies showed money illusion to exist at different levels of inflation in certain countries. Some economists now think that regions with entrenched unemployment, such as the U.S. and the euro zone, with 8.3 and 11.2 per cent respectively, should risk giving higher targeted inflation a go. Apple's share price saves the world!

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