10
Economists should not be surprised that individuals underestimate the effect of inflation
on the demand for their own services. One of the most significant differences between trained
economists and the lay public is economists’ greater appreciation of general equilibrium. The
cognitive difficulty of general equilibrium has been indicated by the fact, noted by the
Commission on Graduate Education, that even economics graduate students do not give the
correct explanation for why barbers’ wages, in the technically-stagnant hair-cutting industry,
have risen over the past century [Krueger, 1991, p. 1044]. If economics graduate students fail to
appreciate the effects on barbers’ opportunity costs from wage increases due to productivity
change outside the hair-cutting industry, it would be a stretch to expect the lay public to see that
as inflation rises the demand for their services (in nominal dollars) will similarly rise with it.
Findings by Shafir, Diamond and Tversky are consistent with those of Shiller. In one
vignette, which they related to respondents, Shafir et al draw the contrast between Ann, with a 2
percent nominal salary increase at zero inflation and Barbara, with a 5 percent nominal salary
increase at 4 percent inflation. Most respondents correctly identified that Ann would be better
off economically, but they also said that Barbara would be happier and less likely to leave her
job. This reaction to the vignette suggests that respondents have not ignored the inflation, as
they would with editing—otherwise Ann would be judged better off economically. But the other
answers, favoring Barbara, suggest that they may also underestimate the effect that inflation will
have on Barbara’s other alternatives thus leading them to conclude that she will be happier and
less likely to quit her job.
Unfortunately, the authors have not probed the reasons why respondents believed Barbara
should be happier than Ann, but they are responding as if the inflation has not increased her
5
The behavior of COLA clauses is consistent with increasing attention being paid to inflation at
higher levels, but there are also other explanations for this phenomenon. As inflation rose in the
1970s and 1980s coverage of union workers by COLA’s in the United States increased. In the
late 1960s about one quarter of workers involved in collective bargains were covered by COLA
clauses; for the inflationary decade from 1975 to 1985 about 60 percent of workers were covered
by COLA clauses (Hendricks and Kahn, 1985, 36-37). As inflation fell in the late 1980s the
fraction covered fell to 40 percent in 1990 (Holland, 1995, p.176). Such inflation sensitivity of
COLAs is consistent with our basic idea that wage and price setters tend to ignore inflation in
their wage and price setting when inflation is low, but tend to take it into account in their wage
and price setting as inflation rises. But this evidence has at least two other explanations. It is
well known (see Ball, Mankiw, and Romer, 1988, p. 56) that the variance of inflation increases
with the level. COLAs may increase at higher levels of inflation as insurance against this
variance. Furthermore, if at higher rates of inflation a greater fraction of inflation is due to
monetary rather than to real shocks, more contracts will be indexed at higher than at lower rates
of inflation (see Gray, 1978).
11
alternatives by an equal amount. If the wages that she could get on the outside as well as all of
the prices that she would be paying had increased by 4 percent then Barbara should be less happy
than Ann and also more likely to leave. Our model of inflation, however, suggests a good reason
why Barbara should feel happier than Ann and be less likely to quit her job: she does not feel that
her alternatives improve at the rate of inflation. Another question by Shiller suggests that the
responses obtained to this vignette reflect the true opinion of the American public. He found
(p.37) that about half of the US general public — but only 8 percent of economists — think that
they would feel more job satisfaction “if their pay went up....even if prices went up as much.”
Neither the vignette by Shafir et al nor Shiller’s question deals with the possibility,
perhaps on the mind of the public, that the inflation is caused by a supply shock that decreases
the real demand for workers rather than a money-neutral demand shock which leaves all demands
unchanged in real terms. Of course, if that is really what is on the mind of the public, even when
there is a persistent demand induced increase in the rate of inflation, then workers will still have
higher job satisfaction with some small amount of inflation than with no inflation.
5
This then is
12
(1)
the third way in which we think that near rationality may impact the relation between inflation
and unemployment. If higher job satisfaction at low rates of inflation leads to higher morale, less
shirking, higher productivity and less turnover, then firms face a different efficiency wage
constraint at low rates of inflation than they face at either zero inflation or at high rates of
inflation when workers’ attitudes towards inflation may become more rational.
A Simple Model of Near-Rational Wage and Price Setting
We now present a simple formal model of the economy that incorporates the behavioral
insights we have just described. In the model, some firms’ wage and price setters may ignore
inflation or firms may be aware of inflation but use it as only one of several factors in setting
wages and prices, thus under-weighting it relative to behavior assumed in hyper-rational models.
And workers themselves may ignore or under-weight inflation when considering their
satisfaction at their current jobs, which in turn affects their productivity. The net effect on unit
labor costs of this behavior by workers may or may not be fully factored into firms’ wage setting.
While the implications of our model for the behavior of the macro economy is not affected by
this aspect of firms’ behavior, we formally consider the case where firms do not correctly
anticipate the effects on worker satisfaction and productivity because this case permits a simple
derivation of the profit shortfall a firm experiences from less than fully rational behavior.
The easiest place to begin the model is with its macroeconomic behavior. Income is
determined by the quantity theory equation,