Explain what role money illusion plays in determining the Fed’s ability to affect output in the short run.

What will be an ideal response?



Money illusion refers to a situation where individuals make mistakes about the distinction between nominal and real magnitudes. For example, individuals might be reluctant to accept a reduction in the nominal wage (that would cause a reduction in the real wage) while at the same time would “accept” a reduction in the real wage when inflation exists and the nominal wage does not change. Money illusion, therefore, might allow a central bank to inflate an economy and, therefore, cause output to rise temporarily.