Costs of Inflation: Price Confusion and Money Illusion

♪ [music] ♪ [Alex] Why is inflation a problem?
To the person in the street, the costs of inflation are obvious.
Prices are going up. What could be worse? But inflation increases
all prices, including wages. If all prices are going up,
what’s the problem? If everyone knew that the inflation rate
would be 2% or 8%, then everyone could prepare. And the exact rate —
it wouldn’t matter so much. But it’s often the case
that no one knows what the inflation rate
is going to be. In the United States,
the inflation rate was 1.3% in 1964. The rate then quadrupled
to 5.9% in 1970. And then it went to 11% in 1974. Inflation caught people by surprise. Then inflation went
from 14% in 1980 to 3% in 1983. And again, people were surprised. And these changes —
they were mild. In Peru, the inflation rate
was 77% in 1986. But then, just four years later, the inflation rate was running
at 7,500% per year before falling back to 73% by 1992. Who could possibly predict
these kinds of changes? Now high rates of inflation
do create some problems, as we’ll discuss, but volatile
and high inflation rates — they’re really costly. We’re going to look at two costs: price confusion and money illusion. Remember from our video
on the price system that a price is a signal
wrapped up in an incentive. We said then that an increase
in the price of oil — it signals to users of oil
that oil has become more scarce. And it incentivizes those users
of oil to find ways to economize, such as by moving flower production
to warmer climates. But when we have inflation,
all prices are increasing. So price signals — they become
more difficult to interpret. There’s price confusion. Is that increase in the price of oil —
is that due to greater scarcity? Or is it just due to more money
chasing the same goods? Now people —
they’re not so sure what to do. And the price system
becomes a less effective way of coordinating economic action. Inflation, especially high
and volatile inflation, it adds noise to prices. So price signals become
more difficult to interpret and coordination is made
less effective. Money illusion is another problem. Let’s face it. Human beings are not
always perfectly rational. So suppose that over several years, the price of a movie ticket doubles. Even when we know that most prices,
including wages, have doubled, we might still feel that movies —
they’ve just become so expensive. “I remember when going
to the movies was a cheap date. It’s too expensive now.” If we think that movies were cheap
in the past and expensive today, we might go to fewer movies, even when there hasn’t been a change
in the real price of movies — the price corrected for inflation. Money illusion is when people
mistake changes in nominal prices with changes in real prices. If we were perfectly rational, then we ought to just care
about the real price. But sometimes that’s hard to do because we compare things
with the way we remember them, without doing all the fancy
corrections and conversions in our head to compare real prices. Inflation has other costs. It redistributes wealth and it breaks down
financial intermediation. We’re going to take up
those costs in the next video. [Narrator] You’re on your way
to mastering economics. Make sure this video sticks
by taking a few practice questions. Or if you’re ready
for more macroeconomics, click for the next video. Still here? Check out Marginal Revolution
University’s other popular videos. ♪ [music] ♪

23 thoughts on “Costs of Inflation: Price Confusion and Money Illusion

  1. In the equation GDP = C+I+G+(X-M), does investment 'I' includes inflow of Foriegn direct investment (FDI) ?

    Does investment 'I' includes spending by domestic businesses only?

    Does investment 'I' includes spending by foreign businesses in the form of Foreign direct investment (FDI) ?

  2. I'd like to see an econ duel on the universal basic income… seems like a genuinely interesting topic that'd suit the Econ Duel format perfectly

  3. I'd like to add a point (or even a correction): not always all prices rise up altogether; more specifically, not always salary rises in the same rate as products. This has been happening here in Brazil: while most salaries have been increased in accordance with a formal inflation index, many products consumed by all people, such as meat and apartments/houses, have increased far more than the average computed by the index. And the there is the variance related to each economic level of the society: poor people don't have a car here, so the inflation related to oil is irrelevant for them compared to bread. In that case, a smaller inflation in oil but bigger inflation in bread may lead to the average value computed by the index and used to raise that poor guy's minimum wage, but he actually suffered in the process.

    At the end, the common Brazilian has actually lost market power since the introduction of the Real.

  4. I can't stand when people teach hogwash .. WAGES ARE STICKY .. especially in rural areas .. and they are usually the last thing to rise especially over the past 30 years .. INFLATION makes us all go broke and sends the money to the top

  5. When was the last time wages adjusted for inflation by doubling? Go ahead and tell people working a minimum wage job demanding "Fight for $15" that inflation is consistently only 2.5%. If you are so sure of your models how about a forecast from all the information we have from 2000-2016? Why is inflation only 2.5% with a National Debt of 22 Trillions dollars? No velocity? The Federal Reserve buying assists?

  6. I love how Volker aggressively wanted to "hammer inflation to zero" It worked, but the medicine tasted so bitter

  7. Inflation is NOT the increase in asset prices! That is the RESULT.
    Inflation is the increase in currency supply. And we’ve NEVER seen such global explosion in currency supply.
    Inflation is NOT good. Stable currency, tied to real money aka PMs, is FAR better than central bank fiat currency.

  8. If money supply is constant, but yet rise in inflation say because of the depreciation or devaluation of the exchange rate, in that case prices will rise creating a higher demand for money. Probably the output has to come in picture because higher output will generate higher amount of money so it money may not be the only factor responsible for inflation

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