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Money Illusion, the Chained CPI, and the Benefits of Inflation

Economists have long recognized the fact that money illusion plays a role in how people behave. Money illusion is the tendency to evaluate the merits of a transaction based on nominal rather than real values.

In an interesting chapter by Eldar Shafir, Peter Diamond, and Amos Tversky in the path-breaking book, Choices, Values, and Frames, these authors reports on a number of experiments where, when presented with various choices, respondents behave in a way that suggests they are influenced by nominal and not just real values.

Keynes recognized that this was one reason why wages are “sticky” – that is, hard to reduce even when prices are actually falling. If prices are falling and nominal wages are reduced, workers are no worse off than before, but they will still resist any cut in their nominal wage because a loss in dollar terms is still hard to bear.

This tendency of behavior to be influenced by money illusion goes well beyond the reaction of employees to wage gains and losses. In the investment arena, a higher rate of inflation leads people to be less fearful about losing money since they tend to evaluate the losses in nominal terms. As a result, when inflation is higher, they tend to undertake more risky investments and end up earning more money by allocating a higher fraction of their portfolio to riskier assets.

Money illusion has played a role in the huge fuss being made about the proposal to change the inflation index for Social Security to the chained CPI. No one seems to realize that under the existing formula, seniors have been getting what could be characterized as an unwarranted adjustment in their benefits measured in real rather than nominal terms. The upward bias in the current inflation adjustment is well known to economists but not to the general public. The public believes that moving to a chained CPI is the equivalent of a benefit cut. A more accurate way of looking at it is as a corrective to what has been a small but automatic increase in real benefits for many years.

An economist reading the literature on money illusion and observing people’s behavior is likely to wring her hands over what seems like irrational behavior on the part of most people. The CPI brouhaha is a nice example. But clouds of irrationality do have a few silver linings.

First, in an inflationary environment, it is easier to reallocate resources from one area to another without lowering the morale of workers or the holders of capital. These reallocations are needed to spur the growth and efficiency of the market.

Second, government budgets often contain tax or benefit program formulas that are not indexed for inflation. Up until the 1980s, for example, income tax thresholds were not indexed with the result that as inflation increased people’s nominal incomes they were automatically moved into higher tax brackets and revenues flowed into the Treasury without anyone complaining very much. A more up-to-date example is setting a nominal threshold for paying an income-tested Medicare premium. If this is not adjusted for inflation, more and more people over time will be drawn into the system. The current thresholds are $85,000 of modified adjusted gross income for single tax filers and $170,000 for joint filers. While this encompasses a very small fraction of all Medicare enrollees now, it will cover far more beneficiaries a decade or two from now, thereby enhancing the solvency of the Medicare system. For better or worse, money illusion is a politician’s best friend.

Finally, there seem to be constant worries that the buildup of assets on the Fed’s balance sheet will lead to inflation. Granted unwinding their holdings could be tricky, but it’s time we stopped worrying so much about small amounts of inflation. Serious inflation is nowhere in sight and will not occur as long as the economy is operating so far below its potential. In addition, for some of the reasons cited above, a little more inflation would not be such a terrible thing.