For example, in Germany perceived inflation was 9.6% in December 2005, although actual inflation was just 2.1% according to the German Bundesbank. Both problems might arise from a fundamental mistake in how people perceive the value of money, which economist Irving Fisher dubbed 'money illusion' almost 80 years ago.
Money illusion means the nominal (face) value of money affects perceptions of its real value. It not only biases individual consumers' and managers' decisions under inflation or when using foreign currencies. It may also have serious macroeconomic consequences as shown by European consumers' price perceptions.
In this working paper, Klaus Wertenbroch, Associate Professor of Marketing at INSEAD; Dilip Soman, Corus chair in communication strategy and professor of marketing at Toronto University; and Amitava Chattopadhyay, the L'Oréal chaired professor of marketing - Innovation and Creativity at INSEAD, examine the psychological processes involved in evaluating transactions in foreign currencies.
Recent mixed findings on consumer valuations in different currencies suggest that the underlying anchoring and adjustment processes are complex. The authors develop an integrative framework to identify boundary conditions that specify the direction of anchoring effects on valuations in different currencies.
Consumers anchor on the numerosity of the nominal difference between prices and salient referents (e.g., budgets) when evaluating transactions. Support for the framework comes from a series of experiments that evoke different reference standards.
In several laboratory experiments with hypothetical as well as incentive-compatible designs, respondents in Hong Kong, the U.S., and Germany were given a budget in a foreign or in their home currency and asked them how much they would spend on various transactions.
It was found that, for a given transaction, people spend less in real terms in a foreign currency than in their home currency when the nominal value of the foreign currency is less than that of their home currency (e.g., for a U.S. consumer in Europe, US$ 1=€ 0.80).
When the nominal value of the foreign currency is higher (e.g. for a U.S. consumer in Singapore, US$ 1=S$ 1.70), consumers spend more. In other words, consumers underspend when using less numerous currencies than their home currency, and they overspend when using more numerous currencies.
The authors show that this occurs because people evaluate transactions by estimating the nominal difference between their budget and the price of a given good or between prices of competing goods. For example, people's real willingness to gamble their own money almost doubled when the nominal value of the currency in which they bet was increased by a factor of 100 while holding the real expected value of the gamble constant.
Respondents reacted to the nominal, not the real, difference between their budgets and the expected value of the gamble. In another experiment, market shares of name brands increased relative to those of private labels when both were priced in less numerous euros than in a more numerous currency. That is because the nominal price premiums of the national brands over the private labels were smaller in euros.
The findings not only explain to marketers how currency denominations affect real spending or private label market shares, they are also consistent with the excessive perceived inflation in much of Europe noted above. Converting national currencies to euros has left consumers feeling nominally poorer than before. This framework may thus provide a psychological explanation for what has puzzled economists and policy makers since 2002.