Don't Ignore Inflation Ignorance: An Experimental Analysis of the Degree of Money Illusion in Individual Decision Making

Abstract

Money illusion refers to the tendency to evaluate economic transactions in nominal rather than real terms. One manifestation of this phenomenon is the tendency to neglect future inflation in intertemporal investment decisions. Empirical evidence for this “inflation ignorance” is hard to establish due to the host of factors that simultaneously change with the inflation rate. We avoid these identification issues by conducting a controlled and fully incentivized investment experiment incorporating a novel set-up for incentivization, the declining conversion rate mechanism. This allows us to quantify the degree of money illusion reliably. We find money illusion to be substantial - even in experimental settings where the bias cannot be driven by a lack of diligence, arithmetic problems, or misunderstandings of inflation. Our findings contribute to understanding various anomalies on the individual and market level, such as insufficient savings efforts or equity mispricing.

Keywords: Money illusion, financial decision making, asset allocation