Tuesday, December 7th, 2010

The Price of Unemployment and Inflation

Unemployment is nearly 10%, the highest in more than a quarter century. Consumer prices, meanwhile, are inching ahead at a pace of barely over 1% a year. And the rate is declining. Nevertheless, Fed chairman Ben Bernanke’s plan to buy hundreds of billions of dollars worth of government bonds to pump money into the economy, reduce the cost of borrowing and hopefully give a shot in the arm to economic activity has attracted a gaggle of critics warning about an imminent threat of runaway prices.

Where does this bias come from? How can the prospect of higher prices in the future cause more anxiety than having one in ten workers out of a job?

Alex Tabarrok of Marginal Revolution points to a survey performed by Robert Shiller in the 1990s  in which he asked Americans to state their preference between two scenarios: one with 2% inflation per year and 9% unemployment and another with 10% inflation per month and 3% unemployment. Three quarters of those surveyed preferred the low inflation scenario –despite the fact that it included 8 million more jobless workers.

As Tabarrok suggests, this might have to do with peoples sense that inflation erodes their purchasing power, and do not realize that inflation will lift wages as well as prices. Perhaps these lopsided responses have to do with the extreme nature of the comparison. Monthly inflation of 10% would seem so out of kilter that an American couldn’t contemplate such a scenario. Still, people’s willingness to tolerate very high unemployment seems unusual, given the fact that unemployment reduces people’s self-reported wellbeing more than inflation.

Based on surveys of self-reported wellbeing in several countries, David Blanchflower of Dartmouth College estimated that a one percent increase in the unemployment rate reduces people’s satisfaction with their lives by about the same amount as having 1.62 percentage-points higher inflation. That means it would take a surge of inflation of 8 percentage points to cause the same kind of unhappiness as the 5 percentage-points jump in unemployment over the last three years. Yet another good reason for Mr. Bernanke to ignore his critics.

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One Response to The Price of Unemployment and Inflation

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