What is money illusion and how can you deal with it?

You might have already heard about cognitive illusions which are situations in which people fail to understand the reality in a proper way. Such illusions also exist in the case of financial management and one of the most popular of them is known as money illusion. Usually, it comes as the willingness to spend more when you receive money and see a large number of your account. Depending on your ability to plan your expenses, you might be more or less prone to spend more than needed at the moment you receive money, yet, in any case you will still find yourself feeling as if your account is filled with money.

An inability of understanding a real value of money

First of all, seeing a large sum of money on a bank account people tend to feel they have a lot of money in the reality which is only an illusion. It is crucial to think about all the necessary expenses waiting for you during the month. Only then, you will see how much money you really have.

Secondly, it is very common for people to misunderstand raise in their salary. Having an increased salary makes people happy as they believe they are now earning more money. In the reality, in many cases people are still earning the same amount of money, as the employer has increased the salary to balance the change in the value of money coming with inflation. This happens quite often, however, money is changing its value all the time while salaries are growing slower. The majority of people just cannot catch the difference in the value of money so quickly and they misunderstand the real value of their salaries.

How do people perceive the value of money?

Irving Fischer noticed the misunderstanding of the real value if money which is very typical for people of different abilities to manage budget in 1928. In 1997 researchers conducted a range of experiments which proved this claim.

During the studies, the respondents were asked to analyse two people who are in the equal financial condition having equal education and salary at the beginning of getting the same job. The difference between these two imaginary people was the area they lived in since in the first place the inflation was equal to zero whereas in the other one it was equal to 4%. The first person has a 2% increase of salary after a year of working in a new place whereas the second person had a 5% increase of salary.

Even though the majority of respondents told found the financial position of the first person better than the condition of the second one which is obvious since considering the level of inflation, the first person was able to buy more than the second one, the respondents found the second person happier. This is connected with the fact we really perceive the increase in such a way, not being able to understand the real value of money when we see an increase in salary.

As you can imagine, in practice it means we tend to feel as if we had more money than we really do which makes us spend more.

What can you do to protect yourself from this psychological issue?

Even though your subconscious mind will still be prone to overestimate your budget, you can take it under control by planning your budget beforehand knowing how much you have to pay for the necessary things. The remaining amount of money is actually what you if you want to buy something just for pleasure.