Monetary effects of inequality: lessons from the euro experiment

Abstract

We propose a new explanation for the decoupling of official and perceived inflation based on relative consumption concerns. In presence of high inequality, when the consumers’ reference point of consumption is more distant to reach, a tight budget constraint is likely to be misperceived as a currency’s loss of purchasing power. Using data from a set of 15 European countries in the period 1990-2008, we estimate the effect of inequality on inflation perception. Our research design exploits the exogenous variation in inequality induced by the reduction in social expenditure that accompanied the implementation of the convergence criteria set up by the Maastricht treaty, in the years preceding the Euro changeover. Our results confirm that an increase in inequality significantly affects the deviation of inflation perceptions from actual inflation.