Behavioral Economics: The Psychology of Inflation


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INTRODUCTION

Behavioral Economics "studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals and institutions and how those decisions vary from those implied by classical economic theory." [Wikipedia. Behavioral Economics. (Accessed October 5, 2021). In its basic form, behavioral economics combines economics with psychology in an attempt to make sense how and why people act and react in real world situations.

Behavioral economics "differs from neoclassical economics, which assumes that most people have well-defined preferences and make well-informed, self-interested decisions based on those preferences." [Witynski, M. Behavioral Economic Explained. (Accessed October 5, 2021). Behavioral economics is based on empirical studies of how humans act, "which have demonstrated that people do not always make what neoclassical economists consider the “rational” or “optimal” decision, even if they have the information and the tools available to do so." [Id]. This field emphasizes that people are indeed human beings, and as such are subject to impulse and emotion in the decision making process and can be influenced by surrounding circumstances and their environment.

THE PSYCHOLOGY OF INFLATION


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Inflationary psychology, in its simplest terms, relates to a human state of mind where people tend to spend more quickly than they normally would based on the belief that prices of the goods in question are rising. The majority of consumers will tend to buy goods now if they possess the belief there will be an imminent price increase. These consumers believe that by purchasing the goods now rather than waiting, they will be saving money.

The basis for inflationary psychology rests on the obvious concept that if people see prices rising now and have seen them rise in the past, then people will then expect further price increases in the future. There exists an apparent positive feedback between present price increases and people's expectations that prices will continue to increase in the future [See, e.g. Investopedia. Inflationary Psychology. (Accessed October 5, 2021).

There exists several models economists have used to demonstrate how the psychology of inflation works:

  • Classical economists tend to describe inflationary psychology either in terms of adaptive expectations or rational expectations, considering it to be nothing more than a normal response to rising prices (that people form their future inflationary expectations by viewing the most recent price increases together with their views and understanding as to how monetary policy as well as interest rates are determinative on inflation).
  • Keynesian economists tend to describe inflationary psychology in terms of 'animal spirits' or discordant waves of pessimism and optimism. To the Keynesian, inflationary psychology is irrational.
  • Behavioral economists tend to describe inflationary psychology in terms of irrational human cognitive biases.

In managing inflationary psychology, the response differs dependent upon how the psychology is described. The classical economist, dealing in rational terms, may view the inflation as not being a major problem responding solely by addressing the cause(s) of the triggering economic policies or conditions present. However, both Keynesians and behavioral economists would adopt a policy either managing or fighting against the inflationary market sentiment as they view the underlying psychology to be an irrational and emotional response to conditions present.

In the US, the Federal Reserve is attentive to developing its understanding of inflationary psychology. Economic negative effects may develop from inflationary psychology requiring intervention by the Federal Reserve. Should inflationary psychology cause inflation to spike, the Federal Reserve may have to step in and raise interest rates to quell the inflationary pressures in the system.

Inflationary psychology can also be particularly troublesome if it continues unchecked. It may cause bubbles to form in various economic markets, such as occurred in the 2000's with the housing bubble. In the early 2000's housing prices increased year over year and people came to expect housing prices to continue to increase. This expectation caused people to purchase housing (be it for ownership or alternatively price speculation) severely reducing the housing supply which drove prices sharply upward. The continued rise in price psychologically lead to more buying and speculation until catastrophe struck the housing market.

As demonstrated in the following graph the housing inflation caused by inflationary psychology pushed the housing market until the bubble burst in 2007.

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THE IMPACT ON INVESTMENTS OF INFLATIONARY PSYCHOLOGY


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The various classes of assets are affected differently by inflationary psychology.

  • The commodity class, such as gold and other precious metals, will most likely rise in price as this class is considered a safe hedge against inflation.
  • The fixed income class will most likely fall in price (as interest earned on fixed assets is inverse to price) yielding higher interest as a response to combat the inflation present in the system.
  • The effect on the equities class is mixed but tending to decrease in price. "This is because the impact of potentially higher rates is much greater than the positive effect on earnings by companies that have the pricing power to increase prices in an inflationary environment." [Investopedia, supra.].

HYPERINFLATION AND THE SELF FULFILLING PROPHECY OF INFLATIONARY PSYCHOLOGY


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In economics, hyperinflation is recognized when the prices of all goods and services in the economy rise uncontrollably over a definite period of time. Simply put, hyperinflation is nothing more than extremely rapid inflation (more than 50%/month).

During periods of hyperinflation, people tend to scramble to stock up on durable goods (machinery, equipment) to avoid paying higher prices the next day. When the hyperinflationary period is prolonged, people tend to stock up on perishable items. However, with people purchasing more to stock, a higher demand is presented which has the undesired effect of prices rising further.

Thus, when hyperinflation is present, inflationary psychology of stocking to beat higher prices become a vicious cycle, ultimately leading to economic collapse. In this way the vicious economic cycle of continuously rising prices due to the expectation of continued uncontrolled price rises supports the concept of inflationary psychology being a self fulfilling prophecy. People believe prices will continue to rise out of control and their actions in fact cause even higher prices (until collapse).

CONCLUSION

By discovering how to recognize and further understand inflationary psychology, Central Banks are afforded additional data and consumer sentiment upon which to base its monetary policy to combat systemic inflation. All with the hope of providing better and more efficient solutions to manage inflation in the economic system.

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