Monetarists usually refer to the concept of money illusion while discussing economic psychology of the people regarding the demand for money. Money has no direct utility except that it possesses purchasing power, and that is its value.
But, common people have money illusion in the sense that they consider utilitarian functions of money directly on the basis of its face value, ignoring its intrinsic worth its purchasing power.
People have extraordinary faith in money. Money is always mistaken as wealth as the be-all and end-all of all values. There is emotional attachment towards money.
As such, when more money is earned people tend to feel happy they have a psychological satisfaction. In reality, they are under an illusion. Workers usually have a strong money illusion.
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When their pay-scales are revised or additional dearness allowances are paid in view of the rising prices, they feel happier even though their real wages has remained unchanged.
People have such illusions about money that they disregard its purchasing power its real value and tend to feel satisfied more by its quantity only.
It is very common that labourers always demand more money wages and will show great resentment if money wage is cut even in a situation of falling prices and enhanced value of money (i.e., appreciation of real wages).
The impact of money illusion is that it makes labour supply function more elastic with a rising money wage rate with rising prices, thus, maintaining real wages at a constant level.
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Again, money illusion has a favourable impact on consumption in the short-run. When people’s money-income rises, along with rising prices (so that real income remains unchanged), there will be a tendency to spend proportionately more on consumption; hence real consumption may rise, despite real income remaining unchanged.