I am sure you have all experienced the feeling that your money is not buying you what it used to.
In the supermarket, products appear to be the same as what you bought previously, but on closer examination, you may find that the loaf of bread has shrunk in size while the price is the same. This is called Shrinkflation. In 2024, Choice listed 10 Grocery items hit by Shrinkflation.
A more technical term is Money Illusion which means that people tend to focus on the Nominal Value rather than the Real Value. The Real Value uses a formula to discount the Nominal Value for Inflation. A simple explanation is Nominal Value less Inflation equals Real Value, but the actual formula is more complex and something most people don’t need to calculate.
The HILDA Report (Household, income and Labour Dynamics in Australia) addresses the issue of Money Illusion. Money Illusion is a concept people may struggle with. The findings of the HILDA Report were:
- Younger adults (15-24) and older adults (65+) have the most difficulty in understanding the concept of Money Illusion.
- People with higher levels of education tend to perform better on questions of Money Illusion
Scenario based questions
Here are some scenarios, I found on Google for you to test your understanding of Money Illusion.
Scenario 1
Imagine your salary increases by 5% next year. The costs of goods and services also increase at 5%. Do you feel wealthier, less wealthy or the same?
Scenario 2
You have $10,000 in a savings account and the interest rate is 2% and Inflation is 2%. Do you feel that that your money is growing in value, just keeping pace or losing value?
Answers to Scenarios
The answers are:
- Because the salary and the goods and services are increasing at the same rate, your nominal and real rates are the same and thus you should feel the same in terms of your wealth. (To be wealthier your salary would need to be increasing at a greater rate than the cost of goods and services)
- Because the interest rate and the inflation rate are the same then, the real value of your investment will remain the same. (If Inflation where greater than the interest rate then the value of your money would be less)
Let’s consider a real life situation you may find yourself. As an example, review your Superannuation. Your fund will most likely provide you with calculators so you can estimate how much money you will have to spend at the start of retirement. Imagine they say that you will have $2,000,000 in 30 years. The purchasing power of that $2,000,000 is dependent on the Inflation rate over this period. Generally, statistics use an average Inflation rate rather than trying to predict the rate each year. The Government’s current policy is to use strategies that will keep Inflation in the 2% – 3% range. The following table will show the Real (Present Value) of $2,000,000 in 30 years with three Inflation Rates.
There is a Present Value difference of $280,168 between the 2% and 3% Inflation Rate. It is highly likely the purchasing power of your superannuation in 30 years is likely to be half the nominal value of your superannuation.
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To find out more, please watch this short video Money Illusion.
To understand the mechanics of Money Illusion, I would recommend the following article from Financial Mappers: How Inflation Impacts Investments.
Glenis Phillips SF Fin – Developer of Financial Mappers and Advice Online
Disclaimer: Financial Mappers does not have an Australian Services License, does not offer financial planning advice, and does not recommend financial products.
