Money Illusion Matters for Consumption-Saving Decision-Making: An Experimental Investigation

By means of an economic experiment, this paper examines the effects of money illusion on consumption-saving decision-making. In the experiment, subjects make sequential consumption-saving decisions in economic situations where nominal values of economic variables are displayed differently but there is no difference in their real values in that an optimal real consumption path is the same. Nevertheless, the experimental results show that a nominal difference arising from a higher positive rate of inflation causes subjects to consume more in early periods of the experiment and less in later periods. Moreover, given the utility function assumed in the experiment and the estimated relationship between the slope of the consumption path and the inflation rate, such money illusion results in a higher level of utility for a subject who confronts a higher positive rate of inflation if the level of the inflation rate is modest. In deflationary situations, a nominal difference stemming from a lower negative rate of inflation generates a similar effect to that from a higher positive rate in terms of the consumption path. These findings suggest that in making consumption- saving decisions, subjects react to a rise of the inflation rate differently in inflationary situations and in deflationary situations, regardless of no change in the real interest rate.