Money illusion is slowly pushing you to the poor house.
Imagine a frog basking in a pot of water that is heating up ever so slowly. If the water heats up too quickly, the frog will sense danger and jump out of the pot. If the water heats up slowly, the frog will remain in the pot through the ever-increasing temperatures until it is too late.
The money illusion works the same way with your personal wealth. A sneaky trick used by central banks and financial engineers is to mask economic growth by slowly introducing inflation into an economy. The inflation is advertised in media headlines as economic growth, but in reality it has the opposite effect of growth by slowly eroding your wealth without raising the specter of financial ruin.
Inherently, we know that inflation is bad, but inflation of 2-3% is also hardly noticeable. Like the frog in the hot water, we get comfortable with it. In fact we’re so accustomed to it that the Federal Reserve has publicly stated that they target inflation of 2-3% per year for a healthy economy. However, the results are devastating – effectively turning a $100,000 into $85,000 in 5 short years! The illusion exists because after 5 years you still see $100,000 in your account.
Studies by behavioral economists show that people will overwhelmingly choose a 2% pay raise with a 4% inflation rate versus a 2% pay cut with a 0% inflation rate. When in reality both scenarios have exactly the same economic result. It is just an illusion that more money is better!
The illusion exists because people fail to understand the difference between real and nominal value. The nominal value of a good is measured by its price quoted in terms of dollars. Whereas the real value is measured by how much its worth compared to another good or service.
Given this definition of real versus nominal value, we can start to understand how the illusion of money tends to erase real wealth through the illusion of economic growth through inflation. Inflation increases the nominal value of the economy – so we all remain happy – while at the same time destroying our real value.