July 21, 2017

Tomorrow's Prices

An interview with Alberto Cavallo on why consumers have such a hard time thinking about inflation

Consumers have trouble predicting price changes, even for goods they buy all the time


We see prices every day. Whether we are grocery shopping, going to the movies, or filling up our cars with gas, we notice the prices of what we buy and how they change over time.

There’s a word for these generally rising prices: inflation. And even though most Americans experience inflation, they still struggle to estimate these price changes even for goods they buy all the time.

In the July issue of the American Economic Journal: Macroeconomics, Alberto Cavallo and his co-authors Guillermo Cruces and Ricardo Perez-Truglia try to understand why consumers have this problem.

Cavallo recently spoke with Diana Schoder of the American Economic Association about how we think about inflation, why our memories might not be as good as we thought, and what policymakers can do to make understanding inflation easier. He also discussed the Billion Prices Project and what life was like under high and rapidly growing inflation in Argentina.

An edited transcript follows and a fuller audio version of the interview can be heard by clicking on the media player below.

AEA: To start off, let's imagine that we're in a supermarket and deciding what to buy. What are you thinking about?

Cavallo: I'm thinking about my needs, I'm thinking about the different options I have in terms of the goods I'm buying, and I'm comparing prices, both prices within the store and prices that are in my mind about other stores.  

AEA: That's exactly what I would say, too. But neither of us mentioned inflation. Is that something we should be thinking about?

Cavallo: It depends. Whenever you are forming your expectations about the prices you will face in the future — we call that inflation expectations — you're going to be considering a lot of your personal experiences, like you were just saying. The truth is we know very little about consumer expectations even though they play a very key role in many of the models that economists have about the behavior of consumers.

AEA: Are people generally good at forming these inflation expectations?

Cavallo: It depends on the environment where you study this. The theory in economics is that consumers are rationally inattentive. The theory suggests that, in a country like Argentina where the stakes are higher in terms of inflation, consumers will spend more time getting informed than they would in a country like the US. That's exactly what we found.



Alberto Cavallo

AEA: Have you ever lived in a high inflation environment?

Cavallo: Yes. I am from Argentina, and I grew up in a hyperinflation setting. Prices were changing so quickly that prices weren't even displayed on the shelves. The people at the cash register would get these lists of prices updated every few minutes, so you would have to rush to make sure you got to the cash register before the person got the updated lists.

AEA: Does our trouble with forming inflation expectations really just come down to how costly getting that information is?

Cavallo: We did some extra experiments on that. What we found is that people do try to use a lot of memories of the prices they have just (paid). Now those memories are very inaccurate. Even though the CPI or the official statistic could be a better metric to tell you about the overall level of inflation in the economy, people do place a lot more emphasis on individual products and their own memory.

"Even though the CPI or the official statistic could be a better metric to tell you about the overall level of inflation in the economy, people do place a lot more emphasis on individual products and their own memory.

                                                                                                                                        Alberto Cavallo

AEA: Could you talk a little about what the Billion Prices Project is and why you started it?

Cavallo: We started the Billion Prices Project almost ten years ago because the Argentinian government started lying about the inflation rate in 2007. There were no other alternative sources of information that could be reliably used to measure the inflation rate. So we started experimenting with software that downloads all the price information about all the individual products being offered for sale, and then we use that information to measure inflation roughly using the same techniques that statistical agencies do.

AEA: From the perspective of a consumer, why is it so important to have transparent and relevant information on inflation?

Cavallo: When a consumer has to decide whether to consume now or save, they should not only worry about the interest rate that the bank is offering. They should also worry about how prices are going to change in the future. That is the key for why we care about the real inflation rate in our consumption and savings decisions. We have a lot of evidence and analysis about the nominal interest rate, but we still don't understand very well how central banks and policymakers in general can affect inflation expectations. And that's the goal of papers like ours.

Inflation Expectations, Learning, and Supermarket Prices: Evidence from Survey Experiments appears in the July issue of the American Economic Journal: Macroeconomics. Music in the audio interview is by Podington Bear