Money Illusion: How Inflation Reframes Three Common Rate Errors

Calling an interest rate “high” or “low” without the inflation context has no economic meaning. Money illusion — reasoning in nominal euros rather than purchasing power — distorts the analysis of households and commentators alike.

Three reasoning biases recur in nearly every commentary on rates: nominal reading, direction confusion, and historical comparison in nominal terms. Each one survives because it is anchored in a number that looks self-explanatory.

Inflation reframes how interest rates should be read. The Eco3min framework on money illusion and the biases that distort economic analysis.

At 4% interest and 5% inflation, a saver loses 1% of purchasing power per year. At 1% interest and 0% inflation, the same saver gains 1%. The first rate looks “high”, the second “low” — yet only the second enriches. According to Eurostat (January 2026), euro area inflation stands at 2.4%. The French Livret A rate, set at 2.4%, delivers a real return of zero. The saver who feels remunerated is in fact treading water — a diagnosis the nominal figure alone cannot deliver.

The three biases that distort the reading

The first bias — money illusion — consists in reasoning in current euros rather than in purchasing power. A 3% nominal wage rise when inflation runs at 4% is a real pay cut. A loan repaid in inflation-eroded euros costs less than its nominal amount. The mechanism, described by Irving Fisher and revisited by Shafir, Diamond and Tversky in the 1990s, systematically distorts consumption, saving and investment decisions. Only the real-rate framework as a compass corrects the bias. It rests on the foundational nominal-versus-real distinction that any rigorous monetary reading takes as a starting point.

The second bias concerns the direction of the move. A cut in nominal rates is automatically read as easing. The same reading appears in the analysis of episodes where markets and recession signals diverge. Yet if inflation falls at the same time — and faster — the real rate can rise. That is exactly what happened in the euro area between mid-2024 and early 2025: the ECB cut by 75 basis points, while core inflation receded by ≈100 basis points over the same window (Eurostat). The real rate edged up despite the nominal easing. Only the real-rate framework picks up that kind of divergence; a purely nominal grid is structurally blind to it.

The third bias concerns historical comparison. Calling current rates “historically high” by reference to the nominal level alone ignores that real rates in the 1980s — with nominal rates at 15% and inflation at 10% — were around 5%. Current real rates, around 0.5% in the euro area, remain historically moderate. The “historically high” claim collapses the moment inflation re-enters the equation.

What these biases cost in practice

For households, money illusion masks the erosion of purchasing power on cash balances during moderate inflation episodes. According to Banque de France data, French household balances on non-remunerated current accounts amounted to ≈€510 billion at end-2025. With inflation at 2.4%, the annual purchasing-power loss on those balances reaches ≈€12 billion — an invisible drag that the nominal-only reading prevents from being perceived as such.

For public decision-makers, the same biases distort the assessment of financing conditions. Budget projections built on nominal rates overstate debt-service costs when inflation runs high, and understate them when it is low. The real cost of debt service — adjusted for inflation — is the only measure relevant to fiscal sustainability over the medium term. Correcting these biases yields a more faithful reading of the real financial conditions economic agents actually face.

Last updated — 4 June 2026