The political economy of inflation

Recent developments in the political economy of inflation

In this paper, Afrouzi et al. argue that the recent economic, social, and geopolitical changes are quite striking, and therefore it is useful to develop a framework that encompasses at least some of them.  Toward this end, the authors modify a standard non-linear New Keynesian model with sticky-price monopolistically competitive firms to include two distinct features: First, the model departs from the conventional approach of employing a linear approximation in the neighborhood of zero inflation in order to shed light on first-order effects that are obscured in the standard linearization around zero inflation of New Keynesian models. Second, the authors introduce political economy factors by assuming that the central bank lacks commitment and uses its discretion, with central bank strategies and private sector beliefs that are a function of payoff relevant variables. Finally, they model the central bank to have preferences that differ from those of households. Afrouzi et al. posit that going forward central banks will be under pressure because rising of geopolitical tensions and protectionist trade policies as well as fiscal pressures arising from aging populations, green transition spending, defense spending due to geopolitical tensions, and industrial policy expansion will all point to higher inflationary pressures.

We argue that for inflation to remain low and stable in the future, political economy factors, such as strengthened central bank independence or more credible public debt policy, would need to offset the global economic pressures now pushing average long-run inflation upwards.

Changing Central Bank Pressures and Inflation
Authors: Hassan Afrouzi, Marina Halac, Kenneth S. Rogoff, Pierre Yared
From: Columbia University, Yale University, Harvard University, Columbia University

The social cost of inflation

In this paper, Stefanie Stantcheva explores the reasons behind the general public’s aversion to inflation. The author conducted two surveys between December 2023 and January 2024 on representative samples of the US population on the survey platform Lucid, a survey marketplace that pools together respondents from different panels. In constructing the surveys, Stantcheva uses a mix of open-ended text and structured questions to capture a broad range of views and convictions. Some of her findings include:

Perception of Diminished Purchasing Power and Costly Adjustments in Budgets: The primary reason for people’s dislike of inflation is the belief that it erodes their purchasing power. Respondents feel that wage increases do not keep pace with rising prices, leading to a perceived decline in living standards. In response to inflation, individuals report making significant adjustments to their consumer behavior, such as reducing the quantity and quality of goods purchased or deferring purchases.

Stress and Emotional Reactions: Inflation triggers stress and emotional responses among people. There is also a sense of unfairness, as respondents believe that wages for high-income individuals grow more rapidly during inflationary periods, exacerbating inequality. In addition, many respondents believe that firms have considerable discretion in setting wages and often choose not to raise them to boost profits.

Lack of Recognition of Positive Associations: The potential positive effects of inflation, such as reduced unemployment or enhanced economic activity, are not widely recognized by respondents.

Inflation as a High Priority Issue: Inflation ranks high among various economic and social issues, with many participants considering it a top priority ahead of other concerns.

Blame for Inflation: Inflation is often blamed on the government and businesses, with a clear partisan divide in responses. Republicans are more likely to blame the government, while Democrats are more likely to blame businesses.

Social and political consequences of inflation: “People’s heightened interest in inflation becomes even more understandable when considering the far-reaching consequences people anticipate, above and beyond the personal impacts.”

Why Do We Dislike Inflation?
Authors: Stefanie Stantcheva
From: Harvard University