Money illusion occurs when people fail to appreciate the difference between real and nominal prices. It occurs when people ignore the effect of inflation when considering if they are better or worse off. It is a deliberate ruse by central banks to distort the economy and destroy your wealth.
Suppose you earn £50,000 per year and are offered a below inflation increase of 2%, you are now earning £51,000 per year, an increase of £1,000 in nominal terms. However, you can only determine if you are really better off when you consider the prevailing rate of inflation. If inflation is 4% for the same period in real terms you only earned £48,960 for the year, you are actually £1,040 worse off than you were before your pay “rise” and £2,040 worse off in real terms. This money illusion can apply to any cash flow including dividends and interest and the asset prices of stocks and bonds. Any nominal increase in price must be adjusted for inflation to eliminate the money illusion.
To understand how inflation transfers wealth from savers to debtors consider the following example.
A person puts £100,000 in savings into a deposit account (let’s assume zero interest) for five years. The inflation rate each year is 4%, so the total inflation over those five years is 20%. That initial deposit of £100,000 is now only worth £80,000 in real terms due to inflation. To increase the money on deposit in real terms, the account would need to provide interest in excess of 4% per annum consistently.
If instead the £100,000 is an interest only mortgage on a house (no principal repayment – amortization) in the same five year period the debt on the house is now only £80,000 in real terms. In addition the value of the house may now have increased in line with inflation and be worth £120,000. Without paying off any of the borrowed amount, the borrower (debtor) owes £20,000 less, and has £40,000 of equity in his house.