Money Illusion

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Definition of 'Money Illusion'

Money illusion is the tendency for people to think about the value of money in nominal terms rather than real terms. This can lead to poor financial decisions, as people may not realize that the true value of their money is decreasing due to inflation.

For example, if a person's salary increases by 5%, but inflation is also 5%, then their real income has not changed. However, many people would not realize this and may think that they are better off because their salary has increased.

Money illusion can also lead to people making poor investment decisions. For example, a person may invest in an asset that is expected to appreciate in nominal terms, but not in real terms. This could lead to the person losing money in real terms, even if the asset appreciates in nominal terms.

There are a number of ways to avoid money illusion. One way is to focus on the real value of money, rather than the nominal value. This means thinking about how much money you can buy with your money, rather than how much money you have in your bank account.

Another way to avoid money illusion is to track the inflation rate. This will help you to see how the value of your money is changing over time.

Finally, it is important to be aware of the psychological effects of money illusion. People tend to be more attached to money that they have already earned, and they tend to be more willing to take risks with money that they do not yet have. This can lead to people making poor financial decisions.

By being aware of money illusion, you can make better financial decisions and avoid losing money.

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