May 7, 2023
Money Illusion and Inflation
Inflation is the decline in the value of currency caused by an increase in the supply of money. The supply of money is increased by excessive government deficit spending or excessively loose monetary policy, typically low interest rates. We measure this decline in the value of currency through an increase in the price of goods and services. That’s it. That is inflation.
The United States, along with much of the developed world, is at the tail end of a surge of inflation that is higher than it has been for more than 40 years. This inflation has affected every good and service, as well as tax revenues and spending. There have also been real effects on prices, unrelated to inflation. Supply chains were clobbered by business closures, and most countries experienced significant labor force shocks due to COVID. People died, and people chose to remain at home. All these affected consumption and prices.
At the same time, COVID caused people to move; some 44 million Americans now work remotely and have much greater latitude to relocate their home. We had an outbreak of avian influenza that forced the destruction of chickens and caused a spike in the price of eggs. Russia invaded Ukraine, causing energy prices to spike.
All these different effects can be confusing, even disorienting. For anyone younger than about 60, this is especially true; inflation has been a peripheral issue thus far in their lives. Growing older is a great gift. Being old enough not to become unhinged over inflation is marvelous.
For younger Americans, who are less seasoned or wise, inflation can lead to what is known as money illusion. That is simply confusing the declining value of currency with a windfall in earnings or tax revenues. Some Nobel Prize-winning research illustrates this concept simply and clearly:
Suppose we all lived on a single island and had a single currency with posted prices for goods and services. We all lived perpetually, and there were no births or deaths, and there was no productivity growth. In that environment, prices and the amount of currency in circulation would never change. Money would simply change hands, at the going price, for all goods and services.
Now suppose someone parachuted money onto the island, instantly doubling the supply of currency. Suddenly, the money available to buy goods and services would double, so nominal demand would also double. But, nothing else on the island changed. There were no more people to make goods or provide services and no productivity enhancing technology. In the simplest model, the result would be a doubling of all prices, and the economy would return to its original condition. The only differences would be that prices and the supply of money would have doubled.
In a more complex model, some goods would be more desirable than others, so demand for them would more than double. Some people would change occupations, and some products would be less desirable. So, prices wouldn’t uniformly double. Also, workers would demand pay increases, and some would get twice their previous earnings, others would get more or less. Some companies might then be more profitable than others, and some workers would be better off, some worse off.
Real world inflation works like this model. Some prices go up more than others, and some workers see better pay increases than others, while some businesses are less profitable, and others more profitable. This sort of variation or stickiness could cause inflation to last longer, but it didn’t cause the inflation, it simply extends the pain.
Money illusion obfuscates the effect of inflation. For example, here in Indiana, the combination of inflation and the real effect of household relocation caused home prices to rise in many places. In turn, the assessed value of those homes rose, as did property tax payments. This has led to a mini-firestorm of anguished taxpayers. But, how bad is it really? Statewide, home price growth has lagged inflation significantly, even in the past 24 months. Today, Hoosiers are paying less of their income in property taxes than at any time in modern history.
Indiana also has tax caps and, more importantly, levy growth caps for local governments. So, even if your property tax assessment rose by 30 percent, with few exceptions you won’t pay more than 1 percent of your property’s value in taxes. More importantly, most Hoosiers won’t see property tax growth of more than 5 percent, which is the maximum levy growth. The result of this arithmetic is that most Indiana property taxpayers will end the next year spending less on property taxes, in inflation-adjusted terms, than they do now and many will face lower tax rates.
The flip side of this is that the cost of government will rise at roughly the cost of inflation. It takes more money to fill a school bus with gas or buy asphalt for roads. The cost of health insurance for police officers will rise, as will all the other inputs to governing. The increase will prove shocking over the coming months.
For example, when Governor Holcomb’s Blue Ribbon Teacher Pay Commission announced a goal of paying teachers an average of $60,000, the value of the dollar was a lot higher. The next budget will probably meet that goal this fall, but in reality that $60,000 pay is today worth less than $51,000. And, unfortunately, inflation is not yet done with us.
Right now, in inflation-adjusted terms, the next biennium budget is larger than the last two budgets. By the middle of next fiscal year, inflation will have reduced the budget to levels lower than the budget passed in 2019, which included the teacher pay increase. Such are the challenges of budgeting during an inflationary period. Most Hoosier teachers will make less by the end of next year than they did in 2019, once we account for inflation.
The effect of money illusion is especially harsh after periods of long-term price stability. Most Americans younger than 60 are so conditioned to large price drops in goods like cell phones, computers or flat screen TVs, that a general price increase is simply unthinkable. Homeowners who are shocked at a 5 percent increase in property taxes make no comparison to the nearly 9 percent cost of living adjustment in Social Security this year.
The coming year should bring inflation back down to targeted levels of 2 percent to 2.5 percent per year. However, prices won’t generally decline. Now would be a good time to get over money illusion and adapt to a new world where prices, along with incomes, are all higher.
About the Author
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Money Illusion and InflationPrice fluctuation could cause inflation to last longer, but it didn’t cause the inflation, it simply extends the pain.View archives