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Neurological Microfoundations of the Money Illusion

There’s a phenomenon out there known as the “money illusion.” This is basically the fact that people feel better about a four percent raise and two percent inflation than they do about a three percent raise and one percent inflation even though, in principle, the purchasing power is the same either way. This seems perfectly intuitive to me, but there’s a certain strand of economist that’s insisted on making it seem mysterious. So via Brad DeLong, here’s an interesting account of an experiment jointly conducted by an economist and a brain researcher to try to better understand the neurological microfoundations of the phenomenon.

The research that really matters, though, is trying to better understand the level of inflation at which price increases become sufficiently noticeable that the money illusion goes away and people start orienting their lives around inflation expectations. That’s big trouble, and it’s known to be big trouble, but I don’t think there’s very good understanding of exactly what sets it off.

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