This Is Your Brain on Money March 30, 2009Posted by Dwight Furrow in Dwight Furrow's Posts, Political Philosophy, Science.
Tags: economics, inflation, money illusion
Economists often talk about a phenomenon called the “money illusion”, which they think is quite paradoxical. Experimental data shows that when people get, for instance, a 5% raise at work and yearly inflation is at 4%, they feel better about their situation than if they had gotten only a 1% raise with no inflation. The alleged paradox is that the buying power in both cases is exactly the same. Economists assume that a rational agent should be indifferent between the two cases.
I don’t really think there is a paradox here. There are lots of possible explanations for why a rational person might prefer the 5% raise, 4% inflation scenario. One’s raise might reflect your value to your employer or assessments of your ability, work habits, or achievements. It is not irrational to want to be appreciated. It may be that people think they have some control over their raises but absolutely none over inflation, which might fluctuate in unpredictable ways. If inflation moderates, we would rather have the 5% raise than the 1% raise.
“We had now confronted our test subjects with two different situations”, Falk explains. “In the first, they could only earn a relatively small amount of money, but the items in the catalogue were also comparatively cheap. In the second scenario, the wage was 50 per cent higher, but now all the items were 50 per cent more expensive. Thus, in both scenarios the participants could afford exactly the same goods with the money they had earned – the true purchasing power had remained exactly the same.” The test subjects were perfectly aware of this, too – not only did they know both catalogues, but they had been explicitly informed at the start that the true value of the money they earned would always remain the same.
“In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario”, declares Bernd Weber, focusing on the main result. “In this case, it was the so-called ventro-medial prefrontal cortex – the area which produces the sense of quasi elation associated with pleasurable experiences”. Hence, on the one hand, the study confirmed that this money illusion really exists, and on the other, it revealed the cerebro-physiological processes involved…
The policy implications?
I suppose this suggests that people prefer inflation to wage cuts when in either case they lose equivalent buying power.