Perceiving the Real Value: An Experimental Exploration of Money Illusion and Inflation Communication
41 Pages Posted: 13 Nov 2017 Last revised: 28 Apr 2018
Date Written: April 16, 2018
In retirement planning, the ignorance of inflation – so-called money illusion – can have severe consequences for financial wellbeing in old age. It thus seems important to make private investors aware of the divergence between future nominal wealth and real purchasing power. Surprisingly, the question of how different types of inflation communication affect the attractiveness of long-term investments is hardly explored. To close this gap, we introduce a novel experimental approach that mimics the divergence between nominal wealth and real purchasing power by a declining conversation rate (DCR) mechanism. We demonstrate the capability of the experimental set-up to systematically examine the role of inflation communication in long-term investments by addressing three specific research questions: (1) Does investment behavior differ if real returns are explicitly communicated and not just an annual inflation rate in addition to nominal returns? (2) Are nominal capital guarantees only attractive to investors if the (real) loss potential is veiled by the inflation communication approach? (3) Are investors prone to money illusion even if real returns and their relevance are explicitly communicated? The results are subtler than the naïve intuition predicts: The behavioral differences between the implemented communication approaches strongly depend on whether the investment product offers a positive or negative real return. With interest rates currently being on historical lows, our findings carry important implications: The optimal inflation communication approach seems to depend on both the general interest rate in the economy and the risk-return properties of the specific investment product.
Keywords: Savings behavior, money illusion, experimental methods.
JEL Classification: C91, D14, D83, D91.
Suggested Citation: Suggested Citation