7
than in the 1960s. One major macroeconomics textbook [Blanchard (1999, pp.153-154)]
describes the Post War United States Phillips Curve by an early period of low inflation, which
was ignored by wage and price setters, and a later period of high inflation, when the coefficient
on last period’s inflation was close to one. Two of the officials who over the past five years have
been most responsible for obtaining the Federal Reserve' s goal of price stability have also
suggested the possibility of inflation-editing. Former Fed Vice Chairman Alan Blinder, in
company with coauthors, Canetti, Lebow and Rudd (1998), has theorized:
A businessman who cannot keep infinite amounts of information in his head may worry
about a few important things and ignore the rest. And when nationwide inflation is low, it
may be a good candidate for being ignored. Indeed, one prominent definition of ‘price
stability’ is inflation so low that it ceases to be a factor in influencing decisions.
Senate testimony of Federal Reserve Chairman Alan Greenspan seems to suggest a similar
view—that at low rates of inflation economic agents may simply ignore it:
By price stability I mean a situation in which households and businesses in making their
savings and investment decisions can safely ignore the possibility of sustained,
generalized price increases or decreases." [See Greenspan (1988, p. 611), italics added].
Second, even when people pay attention to inflation they may not use expectations as
economists typically assume. If economic agents used a formal procedure to make wage and
price decisions they would first use available information to determine a desired real wage or
price change and then add in the amount of inflation they expect between the time they are
making the decision and some time during the period over which they expect the price or wage to
be in effect. But if they make the decisions intuitively -- subjectively considering a number of
factors including inflation simultaneously — there is no reason to expect that the projection will
give the appropriate weight to inflation. One decision heuristic, suggested to us by interviews
8
with compensation professionals, is that information on inflation may simply be averaged along
with other factors to arrive at a nominal wage or price increase. This would mean that an
increase in inflation would lead to the setting of a higher wage or price, but the effect would be
less than one-for-one. Thus less than complete weighting of inflation is the second departure
from full rationality that may influence the relationship between inflation and unemployment.
In fact, textbooks for compensation professionals warn against using the formal
procedure that economists would imagine was standard. For example, Milkovich and Newman
[1984] warn their readers against granting automatic wage and salary increases, including those
for the cost of living. Such automatic grants, they say, reduce the funds available to reward
employees for performance. Similar thoughts are expressed in the Handbook (Rock and Berger
[1991], p556 ) of the influential Hay Group of compensation consultants, in which managers are
advised to “avoid linking salary movement to changes in the cost of living, because this creates
entitlement and reduces the amount of money available to differentiate for performance.”
The third important departure from the hyper-rational model comes from the way workers
perceive inflation. Shiller (1997) has documented very large differences between the intuitive
models of inflation used by the lay public, most of whom are wage and salary recipients, and the
mental accounting of economists who study the effects of inflation scientifically. Wage and
salary earners systematically underestimate the effects of inflation on the wages that their
employers will want to pay them, even in questionnaires where the effects of inflation are quite
explicit, so that it is highly unlikely that inflation is ignored. As a consequence, and especially at
moderate rates of inflation when real wages are not perceptibly eroded, workers’ job satisfaction
may be enhanced by nominal wage increases even if they fail to fully reflect inflation.
9
There is considerable evidence for this reaction on the part of workers. Economists see
inflation as induced by changes in the money supply and thus as having a uniform effect on
nominal wages and other prices so that inflation causes no change in real income. In his
questionnaire study Shiller has shown that, in contrast, the public has no such expectations. For
example, when asked “to imagine how things would be different if the United States had
experienced higher inflation over the last five years” (Shiller, 1997, p.21) only 31 percent of his
non-economist subjects believed that their nominal income would have been higher than in the
absence of inflation. When asked “to evaluate [a variety] of theories about [how] the effects of
general inflation on wages and salary relates to your own experience and your own job,” 60
percent of economists, but only 11 percent of the general public elected that “competition among
employers will cause my pay to be bid up. I could get outside offers from other employers, and
so, to keep me my employer will have to raise my pay too.” A popular answer for the general
public (26 percent), in contrast to economists (4 percent), was: “the price increase will create
extra profits for my employer who can now sell output for more; there will be no effect on my
pay.” (Shiller, 1997, pp.31-32)
The preceding response suggests that the public fails to understand inflation as a general
equilibrium phenomena. They believe that inflation will make them poorer because it bids up the
prices of the goods they consume, but they fail to appreciate fully, if at all, that inflation will also
bid up the prices of other competing factors and other competing workers, thereby resulting in a
rise in their own wages and salaries. Thus, according to Shiller (p. 29), the “biggest gripe about
inflation” expressed by 77 percent of the general public (but for only 12 percent of economists)
was that inflation “hurts my real buying power. It makes me poorer.”
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