Inflation and Income Distribution: Another Form of Inequality

Fixing the Economists Article of the Week

by Philip Pilkington

Noah Smith has a recent post on inflation in which he urges economists to learn to love inflation. We live, as everyone knows, in a period of low inflation and high unemployment and I suppose Smith’s point is that we shouldn’t worry much about inflation and instead focus on income growth. Fair enough. But would-be Keynesian policy enthusiasts really should temper their language.

Real people — and their representatives in government — don’t like inflation much you see. “Irrational nonsense!” says the vulgar Keynesian policy enthusiast, “when the price of everything goes up, your wage should rise as well. Why? Because on average, we are all sellers of something. If you work in a tea shop and the price of tea goes up, your wage can be expected to go up as well, and so forth. Remember, every dollar that one person spends becomes the income of another person!” (The latter part of that quote is Smith).

That sounds great but things are actually a little more complicated. In fact, the man in the street’s distrust of inflation is probably more grounded than Smith’s abstractions. Why? Because inflation has a distributive element: it does not affect all income groups equally.

Last year a friend and colleague, Javier López Bernardo, and I did a mock report for a class we were taking on just this issue. We broke down the CPI and RPI accounts for the UK and reconstructed them to try to account for how inflation might affect different income groups (actually, Javier did a good deal of the dirty work of reconstructing so he should probably get the credit for that).

The results, while a bit rough and ready, are illustrative that inflation almost certainly hits lower income groups harder than higher income groups. The main reason for this is because food and energy inflation tends to be rather high, while the price of cars and electronic equipment and the like tends to be either steady or falling over time. You can see this with respect to the UK in the graph below:

Food and energy, of course, makes up a greater part of the basket of lower income households than it does higher income households. So what we did was we came up with new weights for the RPI which we thought more accurately reflected the baskets of lower income households. Since we did not have access to survey data we had to basically just make up the weights, but I think they are at least somewhat reasonable. Here is a list of the old weights versus the new weights:

And here are the results we got by comparing the RPI with the new lower income group inflation measure:

What we see is that the lower income group basket is more sensitive to price fluctuations than the standard inflation measure. If we had constructed a high income group basket and compared it, the lower income group basket would be even more sensitive again. This means that in times of high inflation lower income groups tend to see their incomes eroded more rapidly than higher income groups.

It is probably not unreasonable to view this in a sort of Duesenberry fashion. What I mean by that is that people generally care not so much about their absolute income level, but rather their income level relative to others. So, if they see, for example, their income being eroded at a rate of 12% in 1990 while the average rate of erosion is about 10% and the rate of erosion of wealthier incomes is maybe 8%, then they are likely to be pretty annoyed.

Of course inflation has other effects too. It redistributes income from creditors to debtors as the real value of debt is eroded. That is generally good for lower income households. But these households do not generally see this or understand it. They do see, however, that their costs are rising while the wealthy family down the road are not experiencing the same pain and this is likely to irritate them.

Keynesian policy enthusiasts should always remember that we live in a democracy; not a technocracy run by them. If they want their policies to be put in place they require the consensus of elected leaders which ultimately means the consensus of the mass of citizens. For this reason it is probably not such a good idea to go around “celebrating” inflation. Indeed, it often comes across as elitist and lacking in any populist appeal which makes it an easy target for libertarian types who prey on peoples’ fears and misunderstandings to spread ignorance and bad ideas.

It is for this reason that I have always admired the Modern Monetary Theorist (MMT) crowd. Their motto is “full employment and price stability” and they have designed a program, the Jobs Guarantee Program, to ensure just that. Their’s is an infinitely more salable, nuanced and thought-through program then the vulgar money-pump Keynesian policy enthusiasts like Smith (together with many of his New Keynesian colleagues).