Money illusion refers to the situation in which some nominal income increases, can generate the mistaken feeling that a person, or a particular group is increasing its real purchasing power, when in fact monetary erosion due to inflation may be decreasing their purchasing power in real terms. Money illusion is a psychological matter as a result of people being biased and thinking in nominal monetary values rather than real, as it may report the illusion of higher purchasing power.
This term was popularized by J.M. Keynes although it was originally coined by Irving Fisher in his “The Money Illusion”, 1928, while dealing with the differences between nominal and real monetary aggregates.
In relation with the Philips-curve, money illusion helps sustain this theory as it will mean workers will perceive their wages in nominal values. When workers think so, they don’t demand an increase in wages to compensate inflation, and therefore firms’ real hiring cost becomes cheaper. Therefore the higher the inflation rate, the more workers a firm can hire, hence, fulfilling the Philips-curve relation.
However, economist such as Milton Friedman and Edmund Phelps believed money illusion was only possible in the short-run as this illusion could not be maintained constantly, due to adaptive expectations. This is why the expectations-augmented Phillips curve was developed.