VIDEO
HIGHLIGHT
Log InSign up
Costs of Inflation: Price Confusion and Money Illusion
SummaryTranscriptChat

Costs of Inflation: Price Confusion and Money Illusion

Why is Inflation a Problem?

Understanding Inflation and Its Impact

  • Inflation leads to rising prices, which are easily noticeable to the public. However, it also increases wages, creating confusion about its overall impact.
  • Predictability of inflation rates (e.g., 2% or 8%) allows for better preparation. The uncertainty surrounding future inflation rates complicates economic planning.
  • Historical context shows significant fluctuations in U.S. inflation rates from 1.3% in 1964 to as high as 14% in 1980, highlighting the unpredictability of inflation.
  • Extreme cases like Peru's hyperinflation (7,500% per year) illustrate the challenges of forecasting and managing inflation effectively.

Costs Associated with High and Volatile Inflation

Price Confusion

  • High inflation creates price confusion; when all prices rise simultaneously, it becomes difficult to interpret price signals accurately.
  • For example, an increase in oil prices could be due to scarcity or simply more money circulating—this ambiguity hampers effective decision-making.

Money Illusion

  • Human irrationality plays a role in how people perceive price changes. Even if nominal prices double alongside wages, individuals may still feel that goods have become unaffordable.
  • Money illusion occurs when people confuse nominal price changes with real price changes, leading them to make suboptimal consumption choices based on perceived value rather than actual purchasing power.

Additional Costs of Inflation

  • Beyond confusion and illusion, inflation redistributes wealth unevenly across society and disrupts financial intermediation processes essential for economic stability.
Playlists: Economics [Intermediate] Pt.1 Principles of Economics: Macroeconomics Unit 7: Inflation and Quantity Theory of Money
Video description

The inflation rate can be somewhat volatile and unpredictable. For example, let’s take the period between 1964 and 1983 in the U.S. The inflation rate jumped around from 1.3% in 1964 to 5.9% in 1970, and all the way up to 14% in in 1980, before dipping back down to 3% in 1983. These dramatic changes, though still fairly mild in the realm of inflation, caught people off-guard. Peru’s inflation rates in the late 1980s through the early 1990s were on even more of a rollercoaster. Clocking in at 77% in 1986, its inflation rate was already quite high. But by 1990, it had jumped to 7,500%, only to fall to 73% a mere two years later. High and volatile inflation rates can wreak havoc on the price system where prices act as signals. If the price of oil rises, it signals scarcity of that product and allows consumers to search for alternatives. But with high and volatile inflation, there’s noise interfering with this price signal. Is oil really more scarce? Or are prices simply rising? This leads to price confusion – people are unsure of what to do and the price system is less effective at coordinating market activity. Money illusion is another problem associated with inflation. You’ve likely experienced this yourself. Think of something that you’ve noticed has gotten more expensive over the course of your lifetime, such as a ticket to the movies. Is it really that going out the movies has become a pricier activity, or is it the result of inflation? It’s difficult for us to make all of the calculations to accurately compare rising costs. This is known as “money illusion” – or when we mistake a change in the nominal price with a change in the real price. Inflation, especially when it’s high and volatile, can result in some costly problems for everyone. Next up, we’ll look at how it redistributes wealth and can break down financial intermediation. Subscribe for new videos: http://bit.ly/1Rib5V8 Macroeconomics Course: http://bit.ly/1R1PL5x Next video: http://bit.ly/2jnFlZp