Thursday, May 31, 2012

Why do people dislike inflation?

Matt Yglesias thinks that if people knew that wages were the biggest component of the price level, they wouldn't be as freaked out by inflation:
[T]he most important price in the economy is the price of labor and the price of labor is equal to workers' incomes, so a general increase in the nominal price level is necessarily a general increase in nominal incomes. But nobody seems to believe that. Instead people are convinced that gasoline and milk are the main prices in the economy, and that a general increase in the nominal price level is necessarily a general decline in real incomes.
This is a pretty common idea: People dislike inflation because of money illusion. They mistake their nominal incomes for real incomes, and mistake consumer prices for the real cost of living. Seems plausible. And it provides a parsimonious explanation for other phenomena, such as downward nominal wage stickiness.

Except that I see a problem with this explanation. Money illusion explains why people dislike hypothetical or prospective inflation, but it does not explain why people are unhappy when inflation actually happens. Suppose real prices and real wages are unchanged, but inflation spikes to 10%. People who suffer from money illusion will tend to be upset when consumer prices rise, but happy when their nominal wages rise. So in this scenario, it seems that their elation at rising "incomes" would at least mostly cancel out their dismay at rising "costs of living". Instead, it seems that actual inflation causes a lot more dismay than elation.

Here's an alternative explanation: Maybe people think that inflation lowers their real wages. Why would they think that? Well, because inflation tends to correlate with lower real wages! Check out this graph, courtesy of Pau Rabana of NYU, which shows the historically observed correlation between inflation and real wages in the U.S.:

This graph clearly shows that when inflation goes up (at time 0), real wages tend to go down over the next few months. That means that inflation really is correlated with an increase in the cost of living for the average American.

Now, of course, correlation does not equal causation, but mistaking correlation for causation seems like a lot easier of an error to make than money illusion. If people see a spike in inflation, they are logically justified in saying "Oh no, here comes an increase in my cost of living!" They are not necessarily justified in saying "If we had taken steps to prevent that inflation, my cost of living wouldn't have gone up." But it is a very short leap of illogic to go from the first statement to the second. 

It's easy to to see how the correlation in this graph could be misleading. People instinctively think that causes precede effects in time, but this is not always the case. For example, what if expected inflation leads actual inflation, and a spike in expected inflation causes real wages to rise, through a forward-looking Phillips Curve kind of effect? 

But on the other hand, maybe inflation really does cause real wages to fall. How would this work? I don't know, because the wage bargaining process is not well-understood. There are a lot of puzzles and mysteries. One possibility, just off the top of my head, is that inflation allows employers to cut real wages more easily without violating implicit contracts. That could be caused by money illusion too, or it could be caused by people thinking that their coworkers might have money illusion. Anyway, that's just a conjecture.

The basic point is: Maybe people don't dislike inflation because they're stupid. Maybe people dislike inflation because they know it's correlated with falling real wages.


  1. Anonymous5:53 PM

    Another reason might be that people regard increases in their wages as due to personal merit, while they regard increases in prices as the evil of inflation.

    The chart you post shows a decrease in real wages over a few months. What happens after that?

    1. Anonymous6:11 AM

      This was my first thought as well. Too slow!

  2. Arrow6:06 PM

    I think the public perception of inflation is analogous to the public's perception of free trade:

    In both cases, the public message of economists is 'I know that what you're seeing in front of you looks bad (factories closing, prices rising, etc...), but a number of good things happen in the economy that you won't see, and in the end the average person in society will be better off than before, if not that, at least as well off.

    The public response to this argument seems to be 'I don't believe you'. It's not an intellectual matter really, as much as it's a case of saying 'given certain losses in front of me, and future (hypothetical) gains, I'd rather not have the certain losses'.

    1. Yep. Risk aversion.

      But on this - doesn't the graph above show that inflation is correlated with PRECEDING real wage increases? Or am I seeing it wrong? This obviously makes economic sense - if people have more money to spend they will push prices up.

    2. But on this - doesn't the graph above show that inflation is correlated with PRECEDING real wage increases? Or am I seeing it wrong? This obviously makes economic sense - if people have more money to spend they will push prices up.

      Yes. But it may not make sense to people!

  3. Hm. Isn't there psychological research suggesting that people feel more pain for a loss of $X dollars than joy from the corresponding gain? Or was that the other way around?

    Which reminds me that I never finished the Kahneman book.

    Anyway, my point is that I would think that people's inflation fears are less likely to be based in rational analysis of what happens to real wages, which are generally opaque, and more likely to be based in psychology.

  4. Anonymous7:16 PM

    How would this work? I don't know, because the wage bargaining process is not well-understood. There are a lot of puzzles and mysteries.

    Well it should be non-mysterious the cost of most goods and services is entirely out of the control of the average person. At the same time, the average person may have some control over their wage increases, it is quite likely limited (especially now that the private workforce is largely de-unionized). Even if a workplace is unionized, wage bargaining still happens at a much slower pace and more intermittently than businesses can push through price increases.

    In other words, people sense an asymmetry and don't like it. Low inflation keeps costs from rapidly outpacing income.

    This of course leaves aside the whole issue of debts and assets.

  5. Ed Dolan has an excellent post on this inflation perceptions.

    first, DO people dislike inflation? How do we know. I mean, if we do a survey "Do you dislike the devil?" most people i think would say "yes." However, is there any real research with properly framed questions like "have you ever met the devil?" "who do you think the devil is?" "what did the devil do to you?"

    in the context of inflation i am guessing people associate "inflation" with the prices of things that change frequently, like food and gasoline. If you asked "do you like everyone's wages going up" they would say HECK YES!! Maybe if you asked "do you like when your wages go up relative to the price of imported goods like oil" people would say YES but of you asked "would you rather have cheap gasoline and mass unemployment or higher gas prices" maybe people would say mmmm... how high are prices going up??

    But that's the point: I am guessing. So we are totally making up an explanation why people dislike a phenomena without even a proper framing is what the thing is people dislike.

    1. Very good point. To the degree that people just don't like the word "inflation", it is probably because a bunch of talking heads on the evening news said "inflation is bad!"...

    2. Yep especially when they play word association football (that's a Monty Python reference) and throw in Zimbabwe and Weimar Republic. Or Goldbugs tell them, if it wasn't for inflation that cent they saved in 1960 would be worth $2000 now (as if nominal returns wouldn't also be affected).

    3. how remiss of me not to mention inflation, zimbabwe, the Weimar republic, gold and "inflation of the money supply."

      rather than "inflation" which has clearly become corrupted, we need new names for phenomena.

      Lets rename "the fed raising everyone's wages simultaneously" to "wicked sick monetary policy." Then when the Dallas Fed Fisher speaks, he'll be against "wicked sick monetary cookies." How can you be against wicked sick monetary cookies?

    4. That sounds quite relevant. The importance of language in economics is underestimated. Consider those two question "Do you like to sweat and get tired?" and "Do you like sport?", you don't need to run a survey to know you won't get the same answers.
      Irrationality goes further than sensitivity to wording. People are for example more worried by the price of oil than by the increase of their insurance bill. It is quite usual to see people drive a few extra-miles in order to fill their tank at the cheapest gas-station, with the cost of the extra miles exceeding what they spared on the price of gas.
      Daniel Kahneman would probably refer to system 1 prevailing over system 2, and find a logical explanation for that. What's puzzling however is that people seemingly never try to improve their understanding of (basic) economics, although they tend to be obsessed with money.

    5. Anonymous1:22 PM

      Most people hate inflation because they are told to hate inflation. Most people don’t know what it means. The class most hurt by inflation, the Capital (rentier) Class, controls the messaging. The debtor class, which benefits from inflation, is full of tools. They don’t have the bargaining power to increase wages to match inflation, at least not on a real-time basis. Unions are weak. Minimum wage is not indexed. Business owners, oh, excuse me, Job Creators, use inflation as a way to justify reduced raises because the cost of input goods has gone up. It’s classic capitalism, or as we should not speak, class warfare.

      Inflation can be useful to drive down real wages. Dr. Krugman and others have been pushing for increased inflation to help rebalance Europe. Wages are sticky and inflation may be a reasonable way to increase labor competitiveness in certain situations. However, the Capital Class, is stanchly opposed so so too is the delusional class – those that think they are, or will soon be, part of the Capital Class.

    6. "inflation" involves all wages and prices going up simultaneously (hence my joke) so it is not "driving down" real wages. Unless you have some other thing in mind, unless you postulate some wages change differently than others.

      "The class most hurt by inflation, the Capital (rentier) Class, controls the messaging. "

      I don't believe that's accurate either. If you were to take a clinical view of it, inflation could actually help creditors more than hurt them by reducing the incentive for the debtors to default. If I am a mortgagee, on the cusp of default, then inflation reduces my incentive to default by reducing the real value of my debt. On the other hand, if i default, the creditor loses the difference between the principal and the value of the house.

      So as a creditor, inflation may help me more than hurt me (to make this concrete: mortgage writedowns are averaging about 2%/year due to foreclosures etc.; at some point i am indifferent to inflation or writedowns, its a question of how delinquencies are affected).

      The "rentier" class also likes to borrow money to invest in multifamily projects, so they benefit when rents and incomes rise relative to the fixed debt cost. The "worker class" aka your parents also have a lot of "savings" in their 401k including treasuries. Maybe its them that we are hurting with inflation. its really hard to say, which makes me skeptical we can identify a real incentive.

    7. Anonymous7:02 PM

      - "inflation" involves all wages and prices going up simultaneously-
      Does it? There is “wage inflation” and “price inflation”. As Noah’s original post indicates, the two don’t always move in exact sync. Matt Yglesias states,” … a general increase in the nominal price level is necessarily a general increase in nominal incomes.” The income distribution has shifted radically in recent decades. Line workers don’t see those general gains the same today as they did in days past. Additionally, it is near impossible to lower nominal wages. Inflation is an easier way to bring down real wages.

      - if i default, the creditor loses the difference between the principal and the value of the house.-
      Yes, but then the creditor gets a nice write-off on their tax liabilities. Higher inflation would help the economy as a whole and float all boats, but it’s all relative – that’s what people care about.

      - The "rentier" class also likes to borrow money to invest in multifamily projects, so they benefit when rents and incomes rise -
      In sync with inflation so of what benefit? The lender suffers.

      -The "worker class" aka your parents also have a lot of "savings" -
      The data don't support this. The wealth of a typical household over the age of 65 is only $170,000. That’s not much over the median home price (less than the median price not too long ago). Social Security is index to inflation, so for most working class seniors inflation will not hit as hard (certainly not good for the few who have private pension, but there are fewer and fewer of those nowadays). Moreover, the way Medicare is structured, and with the rate of healthcare inflation in the U.S., most seniors would feel little difference with inflation at 2% or 5%.

    8. "Yes, but then the creditor gets a nice write-off on their tax liabilities. "

      So if i lose $100, and get a $35 tax credit, that makes me happy?? better not to lose the $100.

      "In sync with inflation so of what benefit? The lender suffers. "

      does the lender suffer? How do you know? maybe they have offsetting liabilities and are hedged?

      -"inflation" involves all wages and prices going up simultaneously- Does it?"

      all wages and prices going up simultaneously is the *definition* of inflation I would say. Now, you cannot have truly frictionless inflation, there is always some redistributive effects. the costs of inflation arise because not everything adjusts simultaneously.

      Overall you missed my point: you cannot pin down an anti inflation agenda to a class warfare issue, its not all that clear who benefits and who suffers (its actually beneficial for many "rich people" to promote inflation as it has a wealth effect and decreases the likelihood of dissaving).

      The *frictions* that inflation introduces are what actually hurts, not the inflation itself. Line workers are losing purchasing power, not because of inflation, but because of a lack of productivity and demand. We actually export trillions of dollars of goods. Maybe we should be worried about improving their skills and training.

  6. As Adam pointed out above, money illusion combined with loss aversion is another potential explanation.

    I just don't think people are sophisticated enough for your story to hold, Noah

  7. Noah, what is the time period covered by that chart?

    Also, I'd second the idea that there's a huge conditioning factor in how the media treats 'inflation', as well as the proven fact that the elites are against it, and are willing to sacrifice others' employment to reduce it.

  8. Why did you type "implicit" before contracts. Explicit wage contracts are nominal (almost entirely COLAs being a thing of the past). Given contracts as written, unexpected inflation should cause low real wages. Even under rational expectations, total inflation is positively correlated with unexpected inflation. Given reality, they are quite similar.

    I'd still say people are confused. I would guess that when real wages decline due to high inflation they recover later. the data you analyse have fairly short leads and lags. That is needed for estimation. Not just estimation by econometricians. We learn about cause and effect using time not just the past causes the future but that the recent past causes the near future(without any limits on lags imposed a priori we would have no way to learn from the data).

    The standard economists view is that the effect of surprise inflation on real wages does not last. My view is that most of the variance of inflation is not predicted by agents. You mention the forward looking Phillips curve -- is there any evidence that there is such a thing in the real world ? But the temporary part makes sense to me. And I am sure that people will generally not recognize that something which is reversed in a few years is temporary.

    1. Why did you type "implicit" before contracts.

      Because I was talking about wage negotiations, when explicit contracts are re-negotiated. Of course explicit contracts are a reason for downward nominal wage stickiness.

      And I am sure that people will generally not recognize that something which is reversed in a few years is temporary.

      Also a good point.

  9. Interesting topic. Is it possible that the relationship between inflation and real wages has something to do with Fed policy and foreign trade? Regarding Fed policy, wage inflation has been the primary concern for a few decades and therefore non-wage inflation has been permitted to reach higher levels. Regarding foreign trade, it seems plausible that the demand for workers in the US is not impacted as much by rising foreign demand as energy and food commodities. Some combination of these factors may lead to most Americans experiencing declining real wages due to inflation.

    If this post's reasoning is correct, deflation may lead to higher real wages. If so, maybe a better question is why do people dislike deflation?

    1. "Regarding Fed policy, wage inflation has been the primary concern for a few decades and therefore non-wage inflation has been permitted to reach higher levels."

      I think this is not true (since non-wage inflation is in fact the target). The argument is that the Fed uses wage inflation as a leading indicator of inflation and this causes it to ratchet real wages down by being overhasty in applying the brakes. The inflation that it has ignored - is asset price inflation - but arguably this has been driven to a significant extent not by Fed policy but by the tax system.

  10. Anonymous11:42 PM

    I assume this is related to the stickiness of wages? It's very hard for employers to lower their employees' wages in nominal terms, but high inflation makes it easy to do that in real terms.

  11. There are two sides to this question, objective and subjective.

    Objectively, setting aside open economy issues, prices people pay are incomes people get, period. They are not equal, they are identical—the same thing. Of course, not all incomes are wages, nor do all wages move at the same rate. The point is that, objectively, the inflation–real wage relationship is about potential changes in the functional distribution of income coincident with inflation, not about “wages versus prices”. I know this is practically baby talk to economists, but there is so much systematic disinformation about this in the media that we have to go through it over and over.

    The other objective factor is net savings. Here matters are partially clear: a change in unanticipated inflation has a corresponding effect on unindexed credit instruments, but the effect on equities is cloudy and contextual.
    Now subjective. Some people may confuse asset and real income performance. There is also the Amour Propre Effect: when my nominal wages go up it is because I am worthy, and it is terrible that my rewards are diminished by a simultaneous rise in the prices of the stuff I buy.

    But I think the main reason people misperceive the impact inflation has, or doesn’t have, on their living standards is the disinformation referred to earlier. Increases in inflation are bad for net creditors, and it is in their interest to persuade all of us that inflation, even in moderate doses, is a great evil that must be combated at all costs. A very effective means of doing this is promulgating the myth that incomes and prices are separate things—that wages are not in fact prices, and that inflation can therefore be considered a “tax”. They may believe this themselves, or it may be guile, or a bit of both. In any event, most of the news media and a large part of the economics profession is complicit in this, so why should we expect their audiences to resist?

    Three afterwards:

    1. I am not monolithically hostile to net creditors. I think saving is fine and economic conditions should be conducive to long-term planning. But when protecting assets, whether from inflation or default, gets in the way of generating income and employment, I think we need the political-economic resources to override the interests of wealth-holders.

    2. My thinking about this comes from years of discussions with my students. I take lots of time to find out their ideas about economics coming into my class—what they think they already know, whether they are aware of it or not. I do this to be able to teach more effectively.

    3. Don’t show Edward Tufte this graph.

  12. Martin3:34 AM


    If the short-run AS-curve shifts downward you get inflation when AD remains on trend.

    1. Purchasing power goes down, less goods to go around.
    2. Less goods to go around, therefore real wages too high.

    You'll get a drop in wages or not much of a rise in wages and people will be able to buy fewer goods.

    1. Martin3:38 AM

      Note that in the post-war period, the US did not really have a deficiency in AD until very recently; higher than expected inflation was therefore often associated with fewer goods.

    2. Sorry to nag, but this is incorrect.

      When you say AS curve shifts downward, I'm assuming you mean to the right? If that's the case, inflation goes down. If you mean AS curve shifts left, then inflation does occur but less goods going around does not mean real wages are too high. Real income shrank.

  13. Anonymous6:13 AM

    Isn't this really a matter of timing? Wages aren't raised continuously, while prices are. Wages are often coupled to (price) inflation, but the wage raise will typically happen afterwards, say at the end of the year. So wage inflation will usually lag price inflation. This explains that rising inflation will lead to lower real wages in the short term (months) because the real wage will typically not be raised immediately, while decreasing inflation leads to higher real wages for the same reason. On average though, the two are coupled, but people don't perceive it as such because of the decoupling in time.

  14. Anonymous8:57 AM

    But how can you expect average American understands the Phillips curve? Working class Americans use to instinctively support inflationary (remember being cucified on a cross of gold?) But suddenly things have changed. Sorry to say it's not because they saw your graph but instead a lack of leadership on the left in trying to explain how inflationary is good for debtors. The same Ideas you write about above still applied a century ago.

    1. Actually it William Jennings Bryan did much better with farmers, who tended to hold net nominal debt positions and while owning land and selling commodities that adjusted prices quickly. McKinley won most of the wage earners vote and industrial states (in part because of his high manufacturing tariff position).

  15. Anonymous9:49 AM

    What about risk aversion, Noah? Price of gasoline can change by 5% on a normal day, while wages usually won't. So if there's a shock in the economy, prices of goods will adjust to the new equilibrium much faster, while it will take more time for wages to adjust. This sequential element adds some chance that wages won't adjust to the "equilibrium", or maybe an additional shock will hit, hence, you don't like the risk of that. May be off completely here.

  16. "One possibility, just off the top of my head, is that inflation allows employers to cut real wages more easily without violating implicit contracts."

    The top of your head is very smart.

    1. Anonymous12:12 PM

      That this is a puzzle to economists is befuddling to me. We have evidence that inflation reduces people's real wages over a certain time period (and doesn't magically make up the difference later). We have an obvious mechanism (salaries are set in nominal terms and don't get updated often). What is the mystery?

  17. Anonymous10:53 AM


    With 5-6% slack in the workforce I think there's plenty of potential for the benefits of reflation to be captured by the newly reemployed rather than the currently employed. Don't forget, "wage inflation" isn't something that just happens to an employed worker. It's called "a raise" and it's something you have to negotiate for, which is not very easy in an environment of excess labor supply. That doesn't mean it's a bad thing, it just means it's not very surprising if the employed majority isn't thrilled by the prospects.


  18. I think an important factor is that price increases are "in your face" right now, while future income adjustments, even ones with a high degree of certainty, don't have the same salience.

    Anecdotes aren't proof, but my wife is fully "hedged" with regard to gas prices by some small oil royalty interests that she inherited. She complains about gas price increases even though her royalty interest income increaes more rapidly (both in $ and %) than her outlays for gas.

  19. Larry Headlund12:57 PM

    Take your perfectly spherical economic actor ...

    You may have noticed that wages are not evenly distributed. Is inflation being driven by a uniform rise in wages, an increase in the disparity or a decrease? Or even, as has been noted, new entrants or re-entrants to employment? Where you are in the spectrum matters. Nor is it true that prices will rise uniformly or 'equitably'. For example, some one who consumes 100% of their income has a difference experience of inflation than someone who consumes 60%. On even more extremely, someone who is on a subsistence level is going to react to a commodity driven increase in the price of bread differently than someone more affluent.

    It is not an intrinsic that wages are the portion they are of price levels rather that the way we measure inflation is designed to focus on more wage increases as opposed to other influences. There are good arguments for this method but it is a choice. For that matter, the use of substitution in the basket of inflation indicators is controversial but I confess I have no idea how it effects the wage composition.

    Then there is the asset side. Inflation tends to benefit those with negative assets. For example, consider two median US families with a single male breadwinner during the 1970s. The one with a mortgage had a different experience than the renter. Even for the one with the mortgage, did the decline in real debt and increase in asset value compensate for the reduction in real wages over the period? Answering that question is not as simple as measuring net wealth during the period.

    It is at least possible that some of the 'wrong' views on inflation are an accurate analysis of that individuals experiences with and expectations of inflation.

    Full Disclosure: It happens that during the late 70s I was in a position (graduate teaching fellowship = fixed income) where I got all the downside and none of the upside of inflation.

  20. I agree that Rajan doesn’t know what his is talking about. I did a blog post criticising an article of his in the Financial Times recently:

  21. I think it's important to recognize that there are two primary causes of inflation (and deflation). One involves the government engaging in too much monetary loosening (or tightening), the other involves real effects (oil becomes scarcer, or foreign demand for it drives up the real price).

    Monetary policy has an ambiguous effect on peoples' purchasing power - looser monetary policy may result in higher inflation, but it may also support stronger growth that more than makes up for that inflation. On the whole, the consensus seems to be that monetary policy that allows for modest inflation seems to be the most conducive to growth (and deflation is poison).

    In contrast, real effects tend to be unequivocally good or bad. If dwindling oil supplies drive the real price of oil up, then that will tend to reduce growth, and increase inflation. Also, unlike monetary policy, which is continuously managed by the Fed, real effects don't occur according to any sort of managed timetable.

    When we talk about inflation in policy terms, what we're really talking about is the power of the central bank to control inflation through monetary policy. It would be nice if Ben Bernanke had a lever he could pull to suddenly increase the supply of global commodities and beachfront real-estate, but it just ain't so.

    However, when we look at data on the effects of inflation, what we see is a combination of the monetary effects, and real effects. And since real effects happen unpredictably, and effects that increase inflation are pretty much always going to slow growth, what this means is that any sudden jump in inflation is almost always going to reduce real buying power. However, that's not because monetary-induced inflation is reducing peoples' buying power, but rather because such shifts are almost always the result of adverse real effects.

  22. Well, I can tell you why people DID mostly hate inflation, the last time we had it in the US (though I don't think they hated it in practice nearly as much as younger people appear to hate it now, in theory). The problem, for people who were employed, was that even for people whose wage gains at least matched inflation (not always the case) the annual joy and relief at a pay rise was more than over matched by the daily grind of rising prices. And since the high inflation was accompanied by a big recession and high unemployment there was the fear of losing your job- or the obvious problem of rising prices for retirees and others on fixed income. Indexing Social Security - and wages for a lot of jobs- to inflation helped to a certain extent with the reality of coping- but nothing much helped the anxiety of wondering how much more prices would rise and how you'd cope in the future. On top of that, high inflation makes our usual coping mechanism for worries about the future- saving money- less effective.

    So basically, we see the daily, relentless rise in prices and erosion of our savings and feel an equivalent daily, relentless anxiety about the future. By contrast, other kinds of personal economic catastrophes- like high unemployment- don't ever come close to being experienced by virtually everyone- and at least initially the victims may actually feel hopeful as they go for interviews and imagine a better job and future.

    Of course none of this explains the horror of high inflation so many people who've never experienced it show. I think that is only explained by the combined forces of propaganda, stories of hyper-inflation never experienced in the US and imaginations run wild.