Inflationary Psychology

Inflationary psychology is a state of mind that leads consumers to spend more quickly than they otherwise would in the belief that prices are rising. Most consumers will spend their money on a product immediately if they think its price is going to increase shortly. The rationale for this decision is that consumers believe they can save some money by buying the product now rather than later.

Inflationary psychology can become a self-fulfilling prophecy, because as consumers spend more and save less, the velocity of money increases, further boosting inflation and contributing to inflationary psychology. Inflationary psychology essentially refers to the apparently positive feedback between currently rising prices and consumers’ expectations that prices will continue to rise in the future. Inflationary psychology rests on the rather obvious basic idea that if prices are rising and have risen in the past, then many people will expect prices to continue to rise in the future.

Economists have developed various models of how exactly inflationary psychology works. Some economists describe inflationary psychology simply as a normal response to rising prices, based on theories of adaptive expectations or rational expectations; that consumers form their expectations of future inflation based (respectively) on their observations of recent inflation and their mental models of how economic variables such as interest rates and monetary policy determine inflation.  Keynesian economists describe inflationary psychology in terms of irrational “animal spirits” or more-or-less irreducible waves of optimism or pessimism. Behavioral economics, on the other hand, describes inflationary psychology more in terms of cognitive biases such as availability bias.  Depending on how one explains inflationary psychology, the implications as to whether it is a problem or what to do about it can be quite different. If inflationary psychology is simply a rational response to current economic conditions or policies, it may not be a problem at all, and it could be the appropriate response to address the economic conditions or policies that are causing inflation.

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