The purpose of this paper is to give the reader an understanding of Brachingers new developed theory of perceived inflation. Additionally, Brachingers new developed Index of Perceived Inflation is introduced analyzed and critically reviewed. Therefore the term paper is structured as followed:
To understand the basic underlying of Brachingers theory, it is necessary to refer to the Prospect Theory, developed by Kahneman and Tversky in 1979. The main focus from Prospect theory is laid on its assumptions. In detail, the first section starts with a brief thought experiment. Afterwards the concept of reference dependency and loss aversion will be introduced.
The second part of this paper deals with Brachingers work on the theory as well as on the Index of Perceived Inflation. It is shown how Brachinger derived his index from the general Laspeyres formula by adjusting for several restrictions from the Prospect theory. This chapter closes by presenting Brachingers results of perceived inflation for Germany in comparison to the actual rate of inflation after the currency changeover.
The last part of this work deals with the criticism on Brachingers new developed theory. In particular, it is shown that Brachingers assumptions and simplifications are inappropriate to fully explain the phenomenon of perceived inflation. Moreover, it is illustrated that Brachingers results are inconsistent with empirical results. Finally, the paper ends up with alternative explanations which are probably capable to explain the inflation as perceived. Lastly, a conclusion is drawn which will sum up the results and the ability whether perceived inflation is revealed or not.
Table of Contents
Table of figures
List of Abbreviations
1. Introduction
2. Methodology
3. A brief Introduction to Prospect Theory
3.1 A thought experiment
3.2 Reference dependency
3.3 Loss aversion
4. Brachingers Index of Perceived Inflation (IPI)
4.1 The consumer price index as a general Laspeyres type formula
4.2 Index of perceived Inflation (IPI)
4.3 Derivation of frequency weights
4.4 Perceived Inflation in Germany after the currency changeover
5. Criticism on Index of Perceived Inflation (IPI)
5.1 Assumptions adopted from the Prospect Theory
5.2 Additional Assumptions of the Index of Perceived Inflation
5.3 Comparison with the European Consumer Survey
5.4 Other effects on perceived inflation in 2002
6. Results and Conclusion
References
Appendix
Table of figures
Figure 1: The value function
Figure 2: Harmonised Consumer Price Index and perceived inflation in Germany from 1/97 to 6/05
Figure 3: The value function with a loss coefficient c=2
Figure 4: Comparison of the IPI (2.0) and the CPI
Figure 5: CPI in contrast to the IPI(c) with different loss aversion coefficients
Figure 6: Calculation according to Brachinger and Calculation of the Annual Rate: a Comparison
Figure 7: German inflation perception in contrast to measured HICP
Figure 8: Cost development of barber services
Figure 9: Cost development of restaurant prices
Figure 10: Cost development of tickets
Figure 11: Cost development of cleaning services
Figure 12: Standardized perceived inflation vs. standardized actual inflation
List of Abbreviations
illustration not visible in this excerpt
1. Introduction
The introduction of the Euro as a legal tender in the beginning of 2002 was followed by a controversial debate on the alleged inflationary effects of the new currency. Particularly, in Germany, as well as in the rest of the Euro area, survey-based measures signaled a much sharper rise in inflation than measured by the official price indices, whose quality was called into question. In fact, the average inflation in the Euro zone turned out to be not exceptionally high. Therefore the launch of the Euro was considered as a success. However, it is puzzling that most EU citizens think that the introduction of the Euro has caused a price increase. Around 70 percent of the people believe that prices have been rounded up. From figure 12 in the appendix it can be seen that in the Euro zone perceived inflation significantly exceeds actual inflation only in the post Euro period. Further on it is noteworthy that this fact does not seem to be the case in non-Euro countries like Sweden, Denmark and the United Kingdom.
Based on that discrepancy, Wolfgang Brachinger developed, in cooperation with the Federal Statistical Office of Germany, a new theory to describe and quantify the phenomenon of perceived inflation in Germany. Nevertheless, his work has caused a controversial debate on the issue of measuring inflation respectively perceived inflation. Thus, the aim of this paper is to present Brachingers theory on the Index of Perceived Inflation (IPI) as well as the criticism on his work.
2. Methodology
The purpose of this paper is to give the reader an understanding of Brachingers new developed theory of perceived inflation. Additionally, Brachingers new developed Index of Perceived Inflation is introduced analyzed and critically reviewed. Therefore the term paper is structured as followed:
To understand the basic underlying of Brachingers theory, it is necessary to refer to the Prospect Theory, developed by Kahneman and Tversky in 1979. The main focus from Prospect theory is laid on its assumptions. In detail, the first section starts with a brief thought experiment. Afterwards the concept of reference dependency and loss aversion will be introduced.
The second part of this paper deals with Brachingers work on the theory as well as on the Index of Perceived Inflation. It is shown how Brachinger derived his index from the general Laspeyres formula by adjusting for several restrictions from the Prospect theory. This chapter closes by presenting Brachingers results of perceived inflation for Germany in comparison to the actual rate of inflation after the currency changeover.
The last part of this work deals with the criticism on Brachingers new developed theory. In particular, it is shown that Brachingers assumptions and simplifications are inappropriate to fully explain the phenomenon of perceived inflation. Moreover, it is illustrated that Brachingers results are inconsistent with empirical results. Finally, the paper ends up with alternative explanations which are probably capable to explain the inflation as perceived. Lastly, a conclusion is drawn which will sum up the results and the ability whether perceived inflation is revealed or not.
3. A brief Introduction to Prospect Theory
Kahneman and Tversky proposed a theory how individuals make decisions under risk circumstances which is known as “Prospect Theory”.[1] Contrarily to standard economic theory e.g. Expected Utility Theory, Prospect Theory is a descriptive theory of human behavior towards risk.
Based on a compelling body of experimental research, Kahneman and Tversky suggested that people do not make decisions the way expected value theory predicts. Therefore it is essential to clarify the basic assumptions and the underlying philosophy of Prospect Theory in order to understand the idea and criticism on Brachingers Index of Perceived Inflation (IPI). Thus, it is necessary to give the reader an understanding of Prospect Theory by starting with a small thought experiment.
3.1 A thought experiment
Assume you have the choice between the following options:
(i) a sure gain of $ 240;
(ii) a chance of 25 % to win $ 1000 and a chance of 75 % to gain nothing.
Which option would you choose? Certainly you would have chosen the sure gain. (84 % of the test persons chose option (i).)[2] As a result the experiment shows that people are averse towards risky choices even though the risky choice predicts a higher expected outcome. (0.25* $ 1000 = $ 250)
Which option would you choose if you consider the following alternatives?
(iii) a sure loss of $ 750;
(iv) a chance of 75 % to loose $ 1000 and a chance of 25 % to loose nothing.
Once again, if you would have decided like the majority of the test persons you would not have chosen the sure loss. (87 % of the subjects went for option (iv))[3] Conversely, to the first experiment, the outcome of the second experiment shows that people act risk seeking when it comes to losses. However, these results are contrary to classic economic theory, which expressly states that the behavior towards risk should only depend on the proportion of wealth of an agent to the value of opportunities for gains or losses.[4]
3.2 Reference dependency
Unlike classic economic theory, Prospect Theory claims that the outcome of a risky game is depending on a specific reference point of an agent. Consequently, the outcome is coded as a gain or loss while the utility functions diverge in the scopes of gains and losses.[5] Hence, it is important to emphasize that the specific location of the reference point is led open by the Prospect Theory. As a result, this issue was met with severe criticism.
Contrary to these critics one could say that the location of the reference point is in most cases, with sufficient certainty, apparent. Mainly, the reference point goes hand in hand with the actual state, the status quo.
A further important aspect to reference points is that people also code gains or losses according to their aspiration level.[6] For instance, a lawyer could aim to achieve a certain yearly profit. Everything which is below that reference point will be coded as a loss whereas additional profit will be coded as a gain.
In short, people tend to avoid risks in the scope of gains and tend to seek risks in the scope of losses. Thus, Prospect Theory proposes an S-shaped value function to illustrate the behavior towards risk. It is noteworthy that the shape of the function is a concave in the scope of gains and convex in the scope of losses. The flexion of the curve illustrates the psychophysical principle that people perceive the difference between 0 and 100 larger as the difference between 1000 and 1100.[7] The break at the reference point implies that people act risk averse in the scope of gains and risk seeking in the scope of losses. Hence, a representative value function can be written as:
(1) [illustration not visible in this excerpt] (with characteristic values for [illustration not visible in this excerpt]=0.88 and λ=2.25)[8]
3.3 Loss aversion
One additional aspect of the value function is that slope of the function is larger in the scope of losses than in the scope of gains. Formula (1) clearly states that the value of a loss (-x) is perceived more strongly (2.25) than the value of an equivalent gain (0.68). This attribute is usually referred to as loss aversion.
illustration not visible in this excerpt
Figure 1: The value function[9]
Loss aversion goes hand in hand with the so called endowment effect. Basically, the endowment effect is a hypothesis which states that people value a good or service more once their property right to it has been established. In other words, people place a higher value on objects they own relative to objects they do not. The question which is left open by Prospect Theory is: Why do people perceive a loss twice as much as an equivalent gain? Several explanations have been offered by scientists from the field of evolution psychology. Thus, experimental evidence suggests that defenders of territory routinely ascribe a higher value to what they have than they ascribe to the same territory if they have to procure it from another. That is, they fight harder to defend a territory than they do to reacquire it, once it has been transferred to another. A leading hypothesis for this well-known and well-studied phenomenon is that there are payoff asymmetries favoring residents (as in, for example, the different future costs to challenger and resident of having to negotiate boundaries with neighbors). The adaptive value of a predisposition to hang on to what you have, once you have managed to get it, may provide both an empirical and a theoretical foundation to understand and predict the endowment effect in humans.[10] Whether this explanation sounds convincing or not, is left to the reader. In the authors opinion these explanations should be handled with great care.
4. Brachingers Index of Perceived Inflation (IPI)
The launch of the new legal tender, the Euro, as non cash currency in 1999 and in cash form in 2002 went efficiently due to professional preparation. However, in all EU Member States the Euro encouraged discussions in which the people expressed their fears and hopes. The most important issue was the price changes caused by the currency changeover. Especially in Germany people have come to perceive the Euro as “Teuro”. (“Teuro” is a German word-play combining “Euro” and “teuer”, the German word for expensive.)
In order to explain the difference between inflation as measured by the official consumer price index (CPI) and the one perceived by the general public, Wolfgang Brachinger developed a new theory of inflation perception including a corresponding Index of Perceived Inflation (IPI).
In order to properly analyze the theory of perceived inflation an outside-in approach has to be taken. Therefore, the focus will be briefly laid on the general conditions after the currency changeover. Afterwards, the general concept of measuring inflation by the Laspeyres index type will be illustrated. Lastly, the index of perceived inflation will be introduced in order to analyze its components as well as to point out the major differences.
Apparently, after the introduction of the Euro in 2002 there was a significant divergence between the official rate of inflation and the perception of the people. In May 2002 the consumer price index (CPI) had risen by 1.1 % over the previous 12 months. Thus, officials pronounced that there was no price hike in the general price level. On the other hand it is remarkable that certain product groups experienced a considerable price increase e.g. groceries (6.7 percent), a glass of beer in a pub (26.1 percent).[11] An illustration of the divergence between the CPI and the perceived inflation can be seen in figure 2.
illustration not visible in this excerpt
Figure 2: Harmonized Consumer Price Index and perceived inflation in Germany from 1/97 to 6/05[12]
So who is right: the official Consumer Price Index (CPI) calculated by the Federal Statistical Office or the consumers with a sticker shock? The answer may lie in the way inflation is calculated. Hence, it is necessary to analyze the elements of the Laspeyres index.
The consumer price index as a general Laspeyres type formula
The consumer price index measures the average price change for all goods and services purchased by households for consumption purposes. It provides a comprehensive picture of the consumer price changes. Items covered are everyday necessities (e.g. food, clothing) as well as rents and consumer durables (e.g. motor vehicles, refrigerators) and also services (e.g. hairdresser, dry cleaning, insurances). The consumer price index is a measure of how the totals of households in Germany are affected by price changes. Single-person households are included, as well as married couples of pensioners and extended families. In the consumer price index for Germany, the price changes for of 740 exactly specified goods and services are combined. Such goods and services are selected with the goal to represent the consumption by households with a sufficient degree of accuracy. The calculation of the German consumer price index (CPI) is a general Laspeyres index with a fixed base year.[13] The current base year is 2000. It can be written as:
(2) illustration not visible in this excerpt
where p denotes for prices and q refers to the quantity. (at the base period 0 respectively the reporting period t). The individual products (goods and services) are labeled with i. By transforming formula (2) we get:
(3) illustration not visible in this excerpt
Whether the Consumer Price Index is calculated after formula (2) or formula (3) depends on the practical feasibility. Due to the available data sets, formula (2) is usually used. The first part of the formula matches the price relatives pt(i)/p0(i). The price relatives of all goods in the basket are then weighted by their corresponding expenditure shares for the base period. From Formula (3) a more general formula can be derived. At this juncture one has to accommodate for the transformation of the price relatives as well as for discretionary weighting factors. These weighting factors must then characterize the conditions in the base period in order for the index to be a Laspeyres type. The general formula can be described as
(4) illustration not visible in this excerpt
where Gi is any non-negative real valued transformation of the price ratios of the good and gi stands for the discretionary base period weights. It is noteworthy that these weights are positive and add up to one.[14]
However, formula (2) also applies for the calculation of the German consumer price index due to the availability of data sets. For most groups of goods details about expenditure are available unlike for quantities.[15]
[...]
[1] See Kahneman, D. / Tversky, A., Prospect theory: An analysis of decision under risk, in: Econometrica, Vol. 47, No.2 (March 1979), p. 263.
[2] See Kahneman, D. / Tversky, A., The Framing of Decisions and the Psychology of Choice, in: Science, Vol. 211, (1981), p. 456.
[3] See Kahneman, D. / Tversky, A., The Framing of Decisions and the Psychology of Choice, in: Science, Vol. 211, (1981), p. 454.
[4] See Markowitz, H., The Utility of Wealth, in: Journal of Political Economy, Vol. LX, No. 2, (1952), p. 156.
[5] See Kahneman, D. / Tversky, A., Choices, Values and Frames in: American Psychologist, Vol. 39, No.4 (1984), p. 343.
[6] See Chip H. / George W., Goals as Reference Points in: Cognitive Psychology, Vol. 38, (1999), p. 84.
[7] See Kahneman, D. / Tversky, A., Choices, Values and Frames in: American Psychologist, Vol. 39, No.4 (1984), p. 342.
[8] See Kahneman, D. / Tversky, A., Prospect theory: An analysis of decision under risk, in: Econometrica, Vol. 47, No.2 (March 1979), p. 278.
[9] Following Kahneman, D. / Tversky, A., Choices, Values and Frames in: American Psychologist, Vol. 39, No.4 (1984), p. 342.
[10] See Jones, D. O., Time-Shifted Rationality and the Law of Law’s Leverage: Behavioral Economics Meets Behavioral Biology, in: Northwestern University Law Review 2001, p. 1185.
[11] See Theunissen, L.: „The Euro and its effect on prices – the perception vs. the reality”, in: Credit Management; Nov. 2003, p. 3.
[12] See Brachinger, W., Euro or „Teuro“?: The Euro induced Perceived Inflation in Germany, in: Wirtschaft und Statistik, (2005), p. 1003.
[13] See Statistisches Bundesamt, http://www.destatis.de/basis/d/preis/vpinfo4.php, (visited on 02/06/2007).
[14] See Brachinger, W., Euro or „Teuro“?: The Euro induced Perceived Inflation in Germany, in: Wirtschaft und Statistik, (2005), p. 1003.
[15] See Brechthold, S. / Elbel, G. / Hannappel, H. P., Messung der wahrgenommenen Inflation in Deutschland: Die Ermittlung der Kaufhäufigkeiten durch das Statistische Bundesamt, in: Wirtschaft und Statistik 9/2005, p. 992.
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