Money Illusion effect:

Money illusion, as used in economics, means the act of people paying attention to the nominal value of money (its face value) and not to its real value, adjusted for inflation or purchasing power. In essence, individuals might feel they are more affluent or better off due to nominal gains in income or assets, without completely taking into account the effects of increased prices.
The following is a more elaborate explanation:
Key features of money illusion:

• Nominal vs. Real Value: Money illusion takes place when individuals confuse nominal values (the amount listed) with real values (what can be purchased with the money).
• Effect of Inflation: Inflation devalues money. If wages rise by 5% and inflation is 5%, individuals’ real income does not change, but they might experience an increase because of the nominal rise.

Examples:

• Wage hikes: An employee earning a 3% raise may feel wealthier, even if inflation has increased by 3%.
• Property values: Individuals may feel richer if the value of their home rises in nominal terms, even if property values, as a whole, have gone up because of inflation.
• Savings: Money illusion can cause underestimation of long-term savings, such as for retirement, as individuals may not accurately factor in the impact of inflation on their savings.

Economic implications:

• Behavioral Economics: Money illusion is something that behavioral economics researches, which delves into the role of psychological factors in economic choice.
• Wage Setting: It can influence wage bargaining and even contribute to reduced real wages if employees are influenced by nominal rises.
• Financial Choices: Money illusion can result in bad financial choices, for example, excessive spending or poor investment decisions.
• Policy Implications: It is vital that policymakers understand money illusion since it can impact responses of individuals to economic policies as well as the way they view economic situations.