Are Chinese individuals prone to money illusion?

Heleen Mees, Philip Hans Franses 20 November 2011



China’s monetary policy and its inflation have got people talking – particularly about the effect on other countries (see for example the eBook edited by Evenett 2010). But what about its effect on China’s people? Are they fooled by money illusion?

To answer this question, we use a unique dataset collected through a well-established survey, which was implemented in Shafir et al (1997). We translated the survey questions to Mandarin, using Chinese names and adapting prices and dates to present respondents with realistic choices in the context of Beijing 2011. For each single survey question we had at least as many respondents as for the original 1997 survey and often we had many more.

Our findings suggest that respondents in China are less prone to money illusion, that is, they are significantly more likely to base decisions on the real monetary value of economic transactions instead of on the nominal monetary value, as compared to respondents in the US. However, if asked explicitly to evaluate an economic transaction in terms of happiness or satisfaction instead of economic terms, respondents in China are as likely as respondents in the US to prefer the transaction with the highest nominal monetary value to the economic transaction with the highest real monetary value.

Our results show that considerations of happiness, morale, and job satisfaction are intimately related with each other, in contrast to economic considerations. The default decision-making framework for respondents in China appears to be dominated by economic considerations, while the default decision-making framework for respondents in the US appears to be dominated by considerations of happiness, morale and/or job satisfaction. This may well reflect the difference in affluence between respondents in the US and China, with the former having already conquered the top layers of Maslow's pyramid of needs while (many of) the latter find themselves still scrambling at the bottom (Maslow 1943). It also suggests that affluent societies are more prone to money illusion and, hence, more susceptible to irrational exuberance (Akerlof and Shiller 2009).

It is important to note that there are two distinct reasons why respondents in China are less prone to money illusion than respondents in the US.

  • First, when asked specifically to judge a transaction on economic terms, respondents in China are more likely to correctly choose the transaction with the highest real monetary value.
  • Second, if no guidance is given on whether to judge a transaction on economic terms or terms of wellbeing, respondents in China are more likely to adopt a decision-making framework that is dominated by economic considerations.

In other words, Chinese people are more likely to correctly choose the transaction with the highest real monetary value instead of the transaction with the highest nominal monetary value.

Money illusion in economic theory

Although recognised early on in the economic literature – Keynes coined the term in the early 1920s and Irving Fisher devoted an entire book to the subject (Fisher 1928) – money illusion still appears to be the stepchild of economic theory. Most economists do not even wish to ponder its existence as money illusion ostentatiously violates the rational expectations postulate that has been so central to economic theorising in the past decades. Recent research, however, shows that money illusion may play a much greater and more disruptive role in the economy than mainstream economists allow for.

In their landmark study, Shafir et al (1997) distinguish three phenomena in the real economy that suggest the existence of money illusion on the part of economic subjects. The first is that prices are sticky. The second is that indexing does not occur in contracts and laws in times of relatively low inflation, as theory would predict. The third occurrence is through conversation, rather than behaviour, that is, people talk and write in ways that seem to indicate some confusion between money’s nominal and real value. We would like to add a fourth phenomenon, which occurs at the intersection of asset markets and the real economy, and that is that parameters from the real economy (interest, dividends) are used as yardsticks for asset pricing.

Brunnermeier and Julliard (2008) show that a reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. People mistakenly assume that real and nominal interest rates move in lockstep. Hence, they wrongly attribute a decrease in inflation to a decline in the real interest rate and consequently underestimate the real cost of future mortgage payments. Brunnermeier and Julliard (2008) show that inflation and nominal interest rates explain a large share of the mispricing in the UK housing market from 1966 to 2004.

Bernanke (2010) asserts that mortgages with exotic features, which lowered monthly mortgage instalments significantly, are to blame for the US housing boom in the 2000s. This suggests not so much money illusion on the part of economic subjects, but rather money delusion. Regardless of the veracity of Bernanke’s claim (mortgages with exotic features accounted for less than 5% of total mortgage originations from 2000–06 (Mees 2011), Brunnermeier and Julliard (2008) find for the US a similar link between housing market mispricing and inflation as for the UK.

Liu (2010) suggests that money illusion may account to a large extent for the mechanism of sharp run-ups in stock prices during the low inflation period in China. Chinese investors failed to recognise that the nominal dividend growth rate would drop significantly, and estimated the value of the future nominal dividend growth rate simply by extrapolating the historical nominal dividend growth rate. According to Liu, long-term low inflation spurred China’s stock market to rise sharply twice via the money-illusion effect last decade.


Research shows that money illusion plays a much greater and more disruptive role in the economy than mainstream economists allow for. Money illusion may account to a large extent for the housing bubbles and busts in the UK and the US in the 2000s that resulted in the Great Recession. Therefore our study, which sheds further light on the phenomenon now for China, seems to be well timed. The results of our survey in China are interesting in their own right, but still we believe there are further issues to be examined.

First, our survey amounts to a cross section and, given China’s rapid development, it would be insightful to carry out similar surveys in future years. When China approaches US economic standards, also in terms of equality and wealth, we may expect that money illusion may become more prevalent in China too.

Second, as the degree of money illusion apparently corresponds with economic progress, it would be interesting to see if other emerging economies, say, in Africa or South America, give similar survey results.

Third, it may be interesting to tie individual responses to individual background characteristics, like age, income/wealth, and education.

Finally, as money illusion can be associated with a few economic conditions that may generate economic downturns, it would be beneficial for China to learn from US experiences, and perhaps carry out educational programmes to inform people about money illusion.          


Akerlof, George A and Robert J Shiller (2009), Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press.

Bernanke, Ben S (2010), “Monetary Policy and the Housing Bubble”.

Brunnermeier, Markus K. and Julliard, Christian (2008), “Money illusion and housing frenzies”, Review of Financial Studies, 21(1):135-180.

Evenett, Simon J (2010), “The US-Sino Currency Dispute: New Insights from Economics, Politics, and Law”,, 15 April.

Fisher, Irving (1928), The Money Illusion, Adelphi Company.

Liu, Renhe (2010), “The Effects of Inflation on China`s Stock Prices: An Explanation Based on Money Illusion Hypothesis”, Working Paper.

Maslow, Abraham H (1943), “A Theory of Human Motivation”, Psychological Review 50(4):370-396.

Mees, Heleen and Philip Hans Franses (2011), “Are Chinese Individuals Prone to Money Illusion?”.

Mees, Heleen (2011), “US Monetary Policy and the Interest Conundrum”, Working Paper.

Shafir, Eldar, Peter A Diamond, and Amos Tversky (1997), "On Money Illusion", Quarterly Journal of Economics, 112(2):341-374.



Topics:  Frontiers of economic research Monetary policy

Tags:  US, inflation, China, money illusion

Associate Professor at New York University Wagner Graduate School of Public Service; Associate Professor in Economics at Tilburg University

Philip Hans Franses

Professor of Applied Econometrics and of Marketing Research, Erasmus School of Economics, Erasmus University Rotterdam


CEPR Policy Research