Money Illusion: Dollars against Rupees

My friends from childhood, and even my brother, would say that I’m “stingy“. However, an Indian girl from Delhi I met some weeks ago, told me that I have “splurging tendencies”. It is, indeed, very confusing. What’s happening?

I realized I’m suffering from Money Illusion, which is when decisions are influenced by nominal amounts of money. What does this mean? Economists tend to think that people who are “rational” will make choices based only on what they could buy or sell with the money they have, and not its nominal amount. This means that $5 dollars shouldn’t make any sense to you in terms of the number (five) but more in terms of what can you buy with them. So having money illusion is when you do pay attention to the nominal money. For example, would you care if your company decides to cut your wage given that the prices in the economy went down? This would mean that your purchasing power is the same after the wage cut than before. If you do care, so you also suffer from Money Illusion. And, interestingly, people do care about this, and this behavior is consistent with previous economic crisis like the Great Depression of the early 30s.

You might have heard that in developing countries, such as India, prices (of services and non-tradable goods) and wages are much lower than in developed countries. So for tourists India could be very cheap. You could have a nice lunch in that hotel for about $10. Probably, in front of the nice hotel, in an Indian local restaurant – where mostly local people eat – you can have lunch even for $1 or $2. However, this is the big problem of the Money Illusion. If I were “rational”, I wouldn’t be thinking of Rupees in terms of US Dollars and how I would never be able to have lunch or buy something for that price in the USA. If I were rational, I would bargain even for 5 rupees (10 cents of a dollar) for the price of an auto rickshaw (small three wheels motorized taxi). As my friend from Delhi told me: “Why shouldn’t you bargain? If you save 5, 10 rupees in every auto-rickshaw ride you would be able to eat more, to buy more and to enjoy more of the money you have in India”. Which means, translated to economic jargon: you should think of the rupees in terms of the purchasing power in India, otherwise, you are NOT RATIONAL! You should think of expensive and cheap in terms of the the price index in India, and not the one in the USA.

So, is this true? Are we people not rational? I’ve been reading the book “Animal Spirits” by (Nobel Prize in Economics laureate) George A. Akerlof and Robert J. Shiller, two Kensyan economists, that try to explain business cycles with human psychology. Among the possible explanations, one of them is Money Illusion, and they bring the wage cuts story that I mentioned at the beggining of this post.In fact, they argue, people do suffer from Money Illusion.

Now, what to do? Should I start thinking in Rupees for what is left of my time in India? I don’t really know. On the one hand I already take only the local bus for 3 rupees to go every day to the office. On the other hand, I still travel in A/C class in the train. So I try to keep this balance in the limbo between rationality and irrationality. What I know for sure is that if I’ll come some day to India and earn my salary in Rupees, most probably, also my Indian friends will start calling me “stingy”. In the long run equilibrium, as all the economist will say, Money Illusion will be over.