Inflation that worry about inflation’s costs increases dramatically

Inflation is the most commonly used economic term in the popular media. A Nexis search in 1996 found 872,000 news stories over the past twenty years that used the word inflation. “Unemployment” ran a distant second. Public concern about inflation generally heats up in step with inflation itself. Though economists do not always agree about when inflation starts to interfere with market signals, the public tends to express serious alarm once the inflation rate rises above 5 or6 percent.

Public opinion polls show minimal concern about rising prices duringthe early 1960s, as inflation was low. Concern rose with inflation in the late 1960sand early 1970s. When inflation twice surged to double-digit levels in the mid andlate 1970s, Americans named it public enemy number one. Since the late 1980s,public anxiety has abated along with inflation itself.

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Yet even when inflation is low, Americans tend to perceive a morality tale in its effects. A recentsurvey by Yale economist Robert Shiller found that many Americans view differences in pricesover time as a reflection of fundamental changes in the values of our society, rather than of purelyEconomists think of inflation more plainly as a “sustainedrise in the general level of prices.” Their concerns focuson questions such as whether inflation distorts economicdecisions. Very high inflation adversely impacts economicperformance, as evidence from cross-country studiesshows. Likewise, moderate levels of inflation can distortinvestment and consumption decisions. Recent U.S.experience with low, stable levels of inflation, in the rangeof 2 to 3 percent, has spurred policy makers to considerthe possibility of achieving zero percent inflation.

Reducing inflation however has costs in lost output andunemployment during the adjustment. Thus, an importantquestion is whether zero percent inflation is sufficientlybetter for the economy than 2 to 3 percent inflation towarrant the effort of getting there. Americans are most concerned that inflation may lower their standard of living — that theirincomes will not keep up with the rise in prices. This anxiety is particularly pronounced for retirees, uneasy about inflation adjustments to theirpensions and financial investments. To plan for retirement requires forming expectations of pricesin the future.

Inflation makes this more difficult because even a series of small, unanticipatedincreases in the general price level can significantly erode the real (adjusted for inflation) value ofsavings over time. Shiller finds that worry about inflation’s costs increases dramatically asindividuals near retirement age. Americans born before or after 1940 differ more in theirevaluation of inflation’s effects than do the U.S. and German populations as a whole.

effects of inflation uncertaintyMany people understand prices rise because of inflation. But they seem to attribute nominalincreases in their wages more to their own accomplishments than to the feedback effect ofTo the extent that they acknowledge feedback effects, most Americans seem to believe in a”lagged wage-price” model of the economy. That is, they assume that price increases occur firstand wage increases follow, often much later.

Shiller’s survey found a striking number of people –over 75 percent of respondents — believe that their income would not fully adjust for severalyears after an inflationary episode. Economists have tried to measure whether wage increases lagprice increases since the 1890s but have consistently found the relationship difficult to estimate. Many people also dislike inflation because they feel it makes it easier for the government,employers, financial institutions, and others to deceive them. Thus, over 70 percent of Shiller’srespondents agreed that “One of the most important things I don’t like about inflation is that theconfusion caused by price changes enables people to play tricks on me, at my expense.” Thus,some employers may “forget” to raise their employees’ wages as much as inflation thereby givingThere is evidence that people do get fooled, at least initially, about their real wages. EconomistsPeter Diamond, Eldar Shafir, and Amos Tversky argue in their recent paper, “On MoneyIllusion,” that people seem to base their sense of satisfaction on nominal earnings, rather than realearnings. Similarly, Shiller found that over half of his respondents agreed with the statement that,”I think that if my pay


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