This is a guest post by Ben McIvor-Redwood, one of our undergraduate students of behavioural economics. If you wish to contact Ben e.g. about internship opportunities etc. then please email david.comerford@stir.ac.uk and I will pass along your message.
Recent high inflation rates of 10.4% have become a significant issue for individuals, businesses, and the economy. Characterized by an increase in the general price level of goods and services.
‘How has inflation become such a problem? Are we making it worse?’
This sustained increase in the price levels has caused a significant decrease in the value of money, creating many struggles, especially for lower-income earners. Factors such as supply-chain issues, that push up the cost of many goods, play a major role in inflation. However, the impact of behavioural economics is often overlooked; many economic models assume people are Bayesian information processors. Instead, people do not always behave rationally, often influenced by emotions, biases, and heuristics, which could be critical to tackling inflation.
Inflationary Psychology
Inflation expectations play a key role in the actual inflation rate. The self-fulfilling prophecy of “inflationary psychology” explains how expectations of higher prices, encourage consumers to spend now rather than later, on the assumption that goods and services will be cheaper now, than later. This increases demand and pushes up prices. Thus, the high inflation expectation causes higher inflation.
This is not the optimal outcome for society, but comes as no surprise to those familiar with the prisoner’s dilemma game; In which the socially optimal outcome is not achieved due to excessive individual dominant strategies.
How do people assess their inflation expectations? Is it rational?
Many people rely on heuristics principles which reduce the complexity of assessing the probability of a certain inflation rate. Heuristics can be useful but can also lead to severe and systemic errors, especially when it comes to inflation. The high inflation rates may increase people’s reliance on heuristics, which may louden the Inflationary Psychology effect.
A stylisation of loss aversion
One heuristic is loss aversion. This refers to people’s tendency to prefer avoiding losses over acquiring gains. The real or potential loss is perceived by individuals as emotionally more severe than an equivalent gain. In the context of inflation, if workers believe that prices will drastically erode their purchasing power, they will demand higher wages to compensate for the expected loss. In turn, firms will increase their prices to cover the higher wage costs, leading to a wage-price spiral.
Availability bias occurs in situations where people assess an event’s frequency or probability by the ease with which instances can be recalled. Gigerenzer introduced the term dread risks to explain low-frequency high consequence events. In the case of inflation, many people may remember events of hyperinflation, such as in Zimbabwe in 2008, these events are very rare but have high consequences, thus are readily accessed by people’s memory. In this case, many firms and consumers may overestimate the actual inflation and increase buying of assets and wage increases. Both these heuristics may amplify the inflationary psychology effect
Crafting behavioural policies to control inflation
Governments and central banks can use various techniques and policies to control inflation. One of which is the Bank of England’s target inflation rate of 2%, which was used as a gauge to either increase or decrease interest rates but also anchored people’s long-run inflation expectations. In many situations, people make estimates by starting at an initial point which influences their estimate. Different starting points yield different estimates. This was shown in an experiment where two groups estimated the value of a multiplication sum in 5 seconds. One group’s multiplication was,
1 * 2 * 3 * … * 7 * 8
The other group’s multiplication was,
8 * 7 * 6 * … * 2 * 1
When attempting the multiplication each person would attempt the start of the expression and estimate the rest. The group answering the latter expression should estimate a higher value due to the result of the first steps of the multiplication being larger, anchoring their estimates at a higher value. With today’s current inflation rate being so much larger than the target rate, people are beginning to anchor their expectations around higher rates.
A better policy to control inflation could be to make saving could be made more convenient. Many employees would like to save more but lack the willpower. Many people display time-inconsistent behaviour and prioritise current and near-time consumption. Contemplate a choice between two rewards, a small one at time t and a big one at time t+1 day, when t is far away, people tend to choose the bigger reward at t+1. But as t approaches zero, the ratio of discounted values increases, leading to many people procrastinating saving and rewarding themselves now at the expense of saving and spending later.
Thus, the government could make it compulsory for businesses to enrol employees on retirement and give them the option to opt out, to reduce consumption within the economy thus reducing the inflation rate. Studies show participation rates of newly eligible workers increasing by 37% with an opt-out model.
In closing, behavioural policies alone will not reduce the impact of the high inflation rate on autonomous consumption. Policymakers need to consider behavioural biases, as these may explain behavioural deviances that may go unexplained if people are considered Bayesian information processors in economic policies.