A study conducted last year by German researchers suggests that the human brain might be wired in such a way that we naturally evaluate the value of our money in a non-rational (and potentially wealth-depleting) way.

The findings could have important applications for people looking to improve their financial management habits (including using credit, taking out loans, saving and budgeting).

Real Value Vs. Nominal Value

To understand the implications of the study, it’s important to understand these terms:

• Real value: This is what a given amount of money is worth in terms of what goods it can buy. In other words, five dollars is equivalent to, say, one 12-inch sub sandwich, two dozen eggs or several liters of soda (depending on where you shop). Real value is so called because it allows us to see money as a tool for purchasing what we need and want.
• Nominal value: This is the numerical value of money. In numerical value, seven dollars is always more than five dollars, even when the two amounts can purchase the exact same goods (for example, at different stores).

A perfectly rational thinker, then, would consider only the real value of her money in any given situation – rather than basing ideas of personal wealth on the number of dollars in the bank, she would consider that amount in relationship to what products and services those dollars could buy.

Medial Prefrontal Cortex: Where the Money Illusion Lies

Unfortunately, as this study reveals, humans are not perfectly rational creatures. Here’s how the study worked:

• Participants were hooked up to brain scanners so that researchers could monitor brain activity under a variety of stimuli.
• Participants were then offered two sets of identical rewards, which were equal in real value but had artificially set nominal value.
• The brain scans revealed that the reward centers of the brain lit up more when participants were offered rewards of greater nominal value, regardless of their real value.

What this means is that, thanks to the way our brains work, we don’t always realize how much (or how little) money we really have. So, next time you get a raise or a pay cut, pay attention to inflation figures before splurging on that new wardrobe – if prices are rising at the same rate as your income, you may not actually be any richer.

Additional Resources

Abstract of the Study

Real Rigidities and Nominal Price Changes (PDF)