Costs of Inflation: Price Confusion and Money Illusion

Course Outline

Costs of Inflation: Price Confusion and Money Illusion

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.

Teacher Resources


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.



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