Tuesday, September 20, 2011

Are we truly indifferent between inflation options?

A standard experiment for seeing if people suffer from money illusion is to ask them whether they’d prefer a nominal wage increase with higher inflation or a nominal wage cut with lower inflation in the manner of Kahneman and Thaler’s surveys. Right?

When respondents prefer the nominal wage+inflation hike, it’s cited as evidence of peoples' irrationality. For instance a typical survey question asked:
"A company is making a small profit. It is located in a community experiencing a recession with substantial unemployment [but no inflationland inflation of 12%]. The company decides to [decrease wages and salaries 7%lincrease salaries only 5%] this year.”
Respondents considered the wage decrease worse than the wage increase, although after adjusting for inflation they're equivalent. In a world where Y=C, then they’re equivalent. But in a world where Y=C-S, and we can generate a better than inflation return on S, it’s better to have the nominal wage hike.

Simple math. I earn $1000 this year and save $100 of it. The other $900 is consumption. I’m offered Kahneman’s choice for next year.
  • If I choose a 7% cut + 0% inflation, I earn $930 and spend $900. If I’d had the $100 of savings invested in TIPS at a .07% plus inflation, I end the year with $130 in the bank which is about 14% of my annual expenditures.
  • If I choose a 5% raise with 12% inflation, I earn $1,050 and consume $1,008, so I can add another $42 to my savings. That $100 of savings invested in TIPS at .07% plus inflation yields $112, so I end the year with $154 in the bank which is about 15% of my annual expenditures.

IE, the two choices are *NOT* equivalent in real terms and workers are right to prefer the nominal wage increase+inflation option. It's a small difference here, but we're only talking about a 1 year change and a tiny investment return above inflation. As you project it out over longer periods, you get a better real return in the inflation adjusted situation.

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