The Problem of Money Illusion in Economics

Money illusion in economic theory has been an assumption rejected for 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. The author of this paper suggests that financial 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, financial markets are imperfect as Minsky has pointed out. Because of these imperfections the possibility of significant long-lasting valuation problems emerges. One reason for this is that in standard economic reasoning the problem of intentional cheating is neglected. 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 the long term to medium term impacts on the economy extremely difficult. The 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 to adjust after overoptimistic prediction about the future economic development. The author, however, considers that there are some early warning indicators which would give the possibility of timely action of policy makers to control ...