2016-30. Dangers of Money Illusion

On Monday we talked about money illusion as one of the cost of inflation. If people have money illusion and there is inflation, they make suboptimal choices.

I have just come across a paper that provides evidence:

Money Illusion and Household Finance" 
CEPR Discussion Paper No. DP11643

THOMAS ALEXANDER STEPHENS, University of Vienna – Department of Economics
Email: thomas-alexander.stephens@univie.ac.at
JEAN-ROBERT TYRAN, University of Vienna, University of Copenhagen - Department of Economics, Centre for Economic Policy Research (CEPR)
Email: jean-robert.tyran@univie.ac.at

We elicit money illusion and match it with financial and sociodemographic data from official registers on a quasi-representative sample of the Danish population. We find that people who are more prone to money illusion hold more of their gross wealth in nominal assets, including bank deposits and bonds, and less in real assets, including real estate and stocks. This bias is robust to controls for education, income, cognitive ability and other relevant characteristics. We further find that money illusion is a costly bias: 10-year portfolio returns are about 10 percentage points lower for individuals with high money illusion.