Scott Sumner  

Never reason from an inflation rate change

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In a new post, Tyler Cowen is skeptical of Paul Krugman's claim that higher inflation hurts the rich. Brad DeLong also expresses some skepticism. I agree with Cowen and DeLong, but would like to quibble with this comment in Tyler's post:

We all know that inflation is extremely unpopular with voters. We also observe that inflation remains extremely unpopular in a variety of northern European economies, which typically have more egalitarian distributions of income (though not always wealth) than does the United States. In any case the top 0.1 percent in those countries has less wealth per capita than in the U.S. and, at least according to progressives, less political influence too.
There are many subtle issues that need to be considered here. The impact of a once and for all change in the price level is very different from a permanent change in the growth rate. The impact of expected changes in the price level are different from the impact of unexpected changes. The impact of inflation in a depressed economy is different from the impact at full employment. Most importantly, the impact of inflation from a demand shock is very, very different from the impact of inflation resulting from a supply shock.

After 30 years of teaching, and observing the results of many public opinion polls, it's clear to me that very few people even know what inflation is. Around 1990 Americans were asked if inflation was higher or lower than 10 years earlier. They said "higher" suggesting they confused inflation with the "cost of living." In addition, they tend to hold their own income constant when contemplating "inflation," which means that poll question results aren't really about "inflation" they are about supply shocks, i.e. lower real income. Guess what, falling real income is unpopular! I often ask my students; "If all wages and salaries rise by 10%, and all prices rise by 10%, has the cost of living actually risen?" About 99% say no, even though the correct answer is yes. Most have taken multiple macro courses. Please stop asking the public questions about "inflation."

There's a risk here that people might assume; "inflation is unpopular, ergo expansionary monetary policy in unpopular." However whereas supply shocks reduce real output, expansionary monetary policy (in a slack economy) boosts AD, and hence real GDP. Higher real GDP is much more popular (or at least less unpopular) than falling real GDP. American's liked the 1960s better than the 1930s. The ECB's tight money policies aren't well understood by the eurozone public (or even the eurozone experts, for that matter.) But the results of that policy are wildly unpopular everywhere except perhaps Germany and Austria. Even the Netherlands is depressed. Sweden isn't in the eurozone, but the Riksbank's tight money policy is about to drive a very fine reformist center-right government out of power. Tight money is Sweden is very unpopular. Inflation is too low, indeed almost zero. Greece has no inflation---how's that working out for the voters?

Forget about inflation; focus on the popularity of things that might cause inflation---supply shocks, monetary stimulus, etc.


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COMMENTS (20 to date)
Aaron Zierman writes:

If people can't understand inflation, do you think they will really be able to correctly identify other things?

It seems the problems are:
1. Definition of terms used
2. Economic illiteracy
3. Media/Political hunting for storyline

Yes, there is a relationship between the three.

TravisV writes:

I think this was a glitch:

"If all wages and salaries rise by 10%, and all prices rise by 10%, has the cost of living actually risen?" About 99% say no, even though the correct answer is yes.

Yancey Ward writes:

Inflation is both popular and unpopular depending what is inflating at a given moment.

Luke G writes:

I think I'm going to need someone to explain the 10 percent cost of living thing to me. I'm with the 99 percent, apparently.

Daublin writes:

Maybe think about the much-maligned "economic policy", rather than narrowly focussing on money.

Here are some things that increase unemployment and lower growth: accounting requirements, minimum compensation laws, anti-firing laws, criminal penalties for corporate mismanagement, and large, distortionary spending--either to bail out cronies, or just as troublingly, to pull our best and brightest workers into boondoggles like Solyndra and electric cars.

It's hard to prove the exact effect of any one of these policies, but any one of them alone is kind bad. All of them together would, one expects, lead to permanently higher unemployment and a lower rate of entrepreneurship.

To contrast, it is not clear how perfect money management can counteract these things. Yes, bad money management can be disastrous. However, the best possible stimulous is just going to make funding easier to acquire; funding is no use, though, if you can't manage to spend it.

MikeP writes:

I too am either with TravisV or in the 99%.

As are the posted answers to a similar quiz question.

Garrett M writes:

Luke,

The cost of living is the nominal cost of living expenses. If all prices go up, then the cost of living goes up. The point is that people confuse cost of living with standard of living.

Scott Sumner writes:

After reading my comment section I don't think anyone could possibly question my "99%" anecdote. Hardly anyone gets it right. Except Garrett. Don't feel bad if you got it wrong.

Yancey, Yup, easy money during a period of slack causes nominal incomes to inflate faster than prices, which is popular.

Daublin, Good monetary policy merely avoids doing further harm. As you say, it can't solve any non-monetary (real) problems.

MikeDC writes:

@Garrett M,

Maybe, but I'd like to hear other folks' answers. I think it depends on whether you're talking about the nominal or real cost of living.

I always tried to drill into my students that ALL COSTS ARE RELATIVE.

Sure, the nominal cost of living goes up, but if nominal income increases in kind then your real cost of living doesn't go up. You don't have to work any harder to get the same stuff, so your cost of living hasn't increased at all.

Pedagogically this is more consistent, and it also has the happy effect of being easier for your students to understand. 99% of them understand it out of the box, and it's a shorter leap, then, to explain the rarer occasions when nominal changes might effect real changes (e.g. monetary policy at large).

MikeP writes:

Yes, the "cost of living" is indeed a vocabulary question. It's especially tricky because the only thing people actually do with "cost of living" is "adjust" it year-to-year or "compare" it place-to-place, thus cancelling out the unit "dollars".

It's almost as though a person who paid attention to the distinction between cost of living and standard of living thought that nominal GDP was really important!

ADD writes:

Let's see, you could interpret that 99% answer as people talking about the real cost of living, or you could just pronounce them all as stupid. What's the point of such a trick question?

Luke G writes:

Thanks, Garrett M.

John B. in NE writes:

Re 'cost of living': even if adjusted for nominal/real issues, there's still the issue of progressive tax rates. If your nominal income goes up 10%, and prices go up 10%, in a place with progressive taxation you will lose purchasing power. That's because you will now pay a higher fraction of your income in taxes.

dannyb2b writes:

I still cant get my head around sticky prices. It seems sticky prices would just result in zero inflation not 1-2%. Shouldn't it be called sticky inflation instead?

Kurt Schuler writes:

The words "cost of living" should be prefaced by the word "nominal" or "real" to make the meaning clear. Insisting on using "cost of living" only for nominal changes is pedantic. And if the cost of living is a purely nominal concept, then apparently it changes when you go from dollars to pesos, or dollars to cents.

Kurt Schuler writes:

The words "cost of living" should be prefaced by the word "nominal" or "real" to make the meaning clear. Insisting on using "cost of living" only for nominal changes is pedantic. And if the cost of living is a purely nominal concept, then apparently it changes when you go from dollars to pesos, or dollars to cents.

RPLong writes:
In addition, they tend to hold their own income constant when contemplating "inflation,"
So the respondents aren't supposed to answer under an assumption of ceteris paribus? Really???
cmprostreet writes:

I'm with Kurt above in that I'd expect to see either "nominal" or "real" in front of "cost of living" in the question. Since neither of these words appeared, I interpreted "actually" to mean "in real terms", since I see no plausible alternative interpretation for the inclusion of "actually".

If the word "actually" doesn't exist to specify "in real terms", then it's only purpose is to obfuscate. I don't think I've seen a single instance elsewhere in economics where "actually" meant "nominally".

I doubt it's just me- the online dictionary includes "really" as the first synonym for "actually".

If the purpose of the question is to test knowledge of a precise definition, the question itself needs to be precisely worded.

Michael Byrnes writes:

@RPLong

The price level can only rise if consumers actually pay those higher prices. No producer will jack up his prices to a point where his product won't sell.

Other factors can, of course, affect the real cost of living, but it is wrong to attribute that to inflation.

W. Peden writes:

On the cost of living point: imagine it from the perspective of someone on a fixed income. If the cost of what they buy goes up by 10%, then it doesn't matter (from their perspective) that average incomes are rising in line with inflation; continuing THEIR lives just got more expensive. It's helpful to talk to those who lived through the Great Inflation on annually fixed incomes to get a sense of what this is like.

To add further evidence that the "cost of living" is a very confused phrase (and thus so is 'inflation') recently the UK Labour party made a big point of talking about a "cost of living crisis". Naturally, one would imagine, this involved focusing on increases in price level. Instead, the focus was on the slow increase in nominal wages!

On the flipside, in the UK we're now hearing how the "cost of living" will stop going up once average wages catch up with inflation, which is expected to occur later this year. Again, "cost of living" is used as a synonym for "standard of living".

And otherwise very intelligent economists like David Laidler seriously claim that the public understands inflation targeting!

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