Rising Prices Are a State of Mind

Between January 2021 and January 2023, consumer prices jumped by more than 10% across advanced economies — far above the usual 4% two-year increase. In Italy prices rose 15.4%, in the euro area 14.1%, and in the United States 14.4%.

During this period, the concerns about inflation rose to be the number one factor in people's lives. For example, in the US, these concerns significantly surpassed the affordability of health care, gun violence, climate change and illegal immigration. Not surprisingly, many analysts even argue that this surge in prices was a decisive factor in the outcome of the 2024 US presidential race.

What are the costs of inflation?

Any student who has taken an introductory macroeconomics course is familiar with the standard answers. From the perspective of firms, inflation forces businesses to update their prices regularly, giving rise to so-called menu costs. For households, inflation eats away at the purchasing power of cash, so people keep minimal money on hand. That forces more frequent trips to ATMs or banks — what economists call shoe-leather costs — resulting in higher transaction costs. 

Economists stress both the costs and the benefits of moderate inflation. For example, in post-World War II data, higher inflation is associated with higher overall growth in advanced countries, which is often rationalized through the Phillips curve, representing a negative trade-off between unemployment and inflation. Additionally, moderate positive inflation helps minimize the chances that a country will be caught in a deadly deflationary spiral, where overall growth and consumer prices fall rapidly. 

Do non-economists perceive the same effects of inflation as economists?

In a famous 1997 study, Nobel laureate Robert Shiller took an unconventional approach by the standards of academic economists at that time. He asked people directly why they dislike inflation so much. He surveyed a representative sample of US, German and Brazilian households about their perceptions of the costs of inflation. Among many findings, Shiller demonstrated that people perceived prices to be growing faster than nominal earnings, thereby eroding the purchasing power of their earnings.

One reason individuals feel their wages lag (even when data show they do not) could be that wages do not automatically increase with inflation. Workers must act proactively by asking employers for higher nominal wages, which may lead to conflicts with their bosses. Not everyone is a natural negotiator. Most people are averse to conflict situations, such as wage bargaining. Even if, ultimately, most workers manage to get wage rises, it is psychologically costly. Recent research by Joao Guerreiro (UCLA), Jonathon Hazell (LSE), Chen Lian (UC Berkeley) and Christina Patterson (Chicago Booth) measured these costs and found them to be pretty significant. Thus, a simple textbook logic that nominal wages keep up with price level increases implies that inflation’s costs are negligible is misleading, because workers must incur psychological and bargaining costs to secure higher wages.

Stefanie Stantcheva (Harvard University) recently repeated and expanded Shiller’s original survey. Having confirmed Shiller’s findings that people hate inflation, she discovered new insights. For example, the respondents did not perceive any positive aspects of inflation, including higher overall growth. 

Economists are still grappling with why most people fail to see any upside to inflation. One compelling theory comes from Rupal Kamdar (Indiana University, Bloomington) and Walker Ray (Chicago Fed), who show that individuals tend to notice price rises most acutely when they coincide with supply-side shocks — like spikes in energy or food costs — that also depress overall growth. In those episodes, higher inflation feels like bad news on two fronts, reinforcing the belief that rising prices inevitably go hand in hand with economic pain. That association leaves little room in the public mind for the idea that moderate inflation, at other times, might be associated with higher overall growth.

Understanding these subjective and psychological dimensions of inflation is not just an academic exercise — it is essential for policymakers seeking to design effective policies that ease the daily burden of rising prices and maintain public trust in government.