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THE PROBLEM OF MONEY ILLUSION IN ECONOMICS

Georg Erber ()

Journal of Applied Economic Sciences, 2010, vol. 5, issue 3(13)/Fall 2010, pages 196-216

Abstract: Money illusion in economic theory has been an assumption rejected by academic economists for quite some time. However, with the gradual diffusion of behavioural economics based on experimental research this has changed. Now, it has become a respected fact to accept money illusion as a stylized fact of human behaviour. However, it still needs a better understanding why monetary phenomena especially related to financial markets play an important role in understanding the real economy, the production, consumption and exchange of commodities and services. Financial markets in comparison to goods markets are particular engaged in intertemporal valuation problems which are common to any kind of economic activity. Since money is the unit of account, accounting problems related to the uncertain nature of future economic development makes a continuous readjustment of valuations in money units necessary. However, as Minsky has pointed out financial markets are imperfect. Because of these imperfections even significant long–lasting valuation problems emerge. One reason is that in mainstream economic reasoning the problem of intentional cheating of market participants is ignored causing false valuations. Furthermore major innovations like e.g. the ICT revolution with the Internet or the introduction of securitization as a means to redistribute risk as general purpose innovations make valuations of long term to medium term impacts of these innovations on the economy extremely difficult. Recent financial market bubbles are significantly related to such general purpose innovations. If monetary policy fails to control for irrational exuberance of investors about the future benefits and profits of such innovations, this inherently embodies the risk of a financial market shock, if expectations of the general public have suddenly to adjust after overoptimistic prediction about the future economic development.

Keywords: money illusion; imperfect financial markets; regulatory failure; behavioural finance (search for similar items in EconPapers)
JEL-codes: G01 G17 G18 G28 (search for similar items in EconPapers)
Date: 2010
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Working Paper: The Problem of Money Illusion in Economics (2010) Downloads
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