How is Perceived Inﬂation Related to Actual Price Changes in the European Union

8/19/2019 How is Perceived Inflation Related to Actual Price Changes in the European Union

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How is perceived inflation related to actualprice changes in the European Union?

Gerrit Antonides *

Department of Social Sciences, Wageningen University, P.O. Box 8130, 6706 KN Wageningen, The Netherlands

Received 11 January 2007; received in revised form 12 March 2008; accepted 6 April 2008Available online 15 April 2008

Abstract

We analyze for which types of consumer expenditures the rate of price change influences con-sumer perception of inflation. We use both harmonized consumer price indices (HCPI) and seriesof perceived inflation from Eurostat in the 1996–2006 time period for 13 European countries. After

removing substantial autocorrelation, we found a significant effect of the rate of overall price changeon perceived inflation in the EU as a whole and a number of individual countries, supporting Fech-ner’s law. However, in different countries different consumer item categories were correlated withperceived inflation. 2008 Elsevier B.V. All rights reserved.

JEL classification: D12; D40

PsycINFO classification: 2340; 3920

Keywords: Perceived inflation; Price change

1. Introduction

Consumer prices, according to economic theory, result from the market volumes of demand and supply of goods and services, given the current production technology. Indi-vidual consumer demand usually depends on the consumer budget and market prices,

0167-4870/$ - see front matter 2008 Elsevier B.V. All rights reserved.

doi:10.1016/j.joep.2008.04.002

*

Tel.: +31 317 483897; fax: +31 317 485373.E-mail address: [email protected]

Available online at www.sciencedirect.com

Journal of Economic Psychology 29 (2008) 417–432

www.elsevier.com/locate/joep

mailto:[email protected]:[email protected]


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assuming that consumers correctly perceive market prices. However, the latter assumptionmay be questioned given the consumer’s limited ability of perceiving prices and pricechanges. Hence, the process of price perception is of interest to the area of economic psy-chology and consumer policy making.

Analysis of data from Eurostat and the EU Business and Consumer Surveys sug-gests that perceived and actual price changes diverge, especially after the introductionof the euro (Aalto-Setälä, 2006; Dziuda & Mastrobuoni, 2005).1 This finding may beexplained from both cognitive processes and statistical procedures summarizing pricechanges.

Cognitive processes in price perceptions are related to reference prices, memory, calcu-lation, price level and price experience. In general, reference prices are used as a bench-mark to judge the attractiveness of a stimulus price (Janiszewski & Lichtenstein, 1999).Reference prices usually depend on (some aggregate of) past prices paid (Kalyanaram &Winer, 1995), the accuracy of which is dependent on the consumer’s memory of paidprices.

Price perceptions may be incorrect because of incomplete memory of prices (Kemp,1987), rounding of exchange rates between national currencies and the euro (Dziuda& Mastrobuoni, 2005), not updating prices in the case of infrequent purchases (Jonung,1986), or never knowing the price in the first place. Dickson and Sawyer (1990) foundthat only 47% of consumers correctly recalled prices paid immediately after purchase,whereas 56% gave a price within 5% of the objective price. Incorrect price perceptionsprovide incorrect reference prices, possibly leading to incorrect perceptions of pricechanges.

Furthermore, price evaluations may be biased by perceptions of price unfairness ( Bol-ton, Warlop, & Alba, 2003), low purchase frequency and steep price changes of particulargoods (D’Elia, 2005; Fluch & Stix, 2005). Although Kemp (1987) to some extent dealt withgeneral costs, the cognitive processes described typically comprise individual reactions toprice changes of isolated goods and services, not to reactions of the general public to priceschanges across consumption categories.

At the aggregate level, the divergence between perceived and actual price changes can-not be fully explained from cognitive processes. Economic data usually capture pricechanges by using price indices, which essentially reflect changes in aggregated prices,i.e., weighted averages of a large number of price changes in different item categories.

Hence, inflation perceptions may deviate from price indices due to differences betweenperception processes and statistical procedures in constructing the price indices. Here,we will focus on the relationship between statistical price indices and inflation percep-tions measured in the EU Business and Consumer Surveys. First, the process of per-ceived inflation and the construction of price indices will be explained. Next, the dataand the empirical analyses will be described. Finally, we comment on the results anddraw conclusions.

1

We distinguish prices, referring to the current or past price level of consumer goods, and price changes, orinflation, referring to the difference between current and past prices. Furthermore, perceived prices refer toconsumer perceptions of current or past price levels, whereas perceived price changes, or perceived inflation, referto consumer perceptions of price changes. Consumer price evaluations refer to consumer judgments of priceattractiveness, presumably based on price perceptions or inflation perceptions.

418 G. Antonides / Journal of Economic Psychology 29 (2008) 417–432


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2. Perceived inflation and price changes

Perceived consumer inflation research has largely focused on judgments of pricechanges, especially after the introduction of the euro. Judgments of price changes have

been based on the idea of reference prices, usually based on the consumer’s memory of past prices paid. One of the first questions asked in consumer research concerning per-ceived price changes was whether consumers were able to report on price changes at all(Gabor & Granger, 1961). For several food items, perceived price changes were foundto be higher than actual price changes, due to exaggeration of price increases and mentalshortening, or telescoping, of the time interval over which the price changes had occurred(Bates & Gabor, 1986). Dickson and Sawyer (1990) found that incorrectly recalled priceson average were 4% lower than actual prices, thus contributing to perceived priceincreases.

Kemp (1987) found slightly over-estimated inflation perceptions for the previous yearbut under-estimated perceived inflation for the previous 15 years. He also mentions thepossibility that experience with purchases, i.e., for frequently purchased items such asstamps, butter and telephone bills, tends to strengthen these effects. Experience may addto the availability bias (Tversky & Kahneman, 1974), possibly resulting in greater weightof high-frequency purchases in perceived inflation judgments. In another study, Kemp(1991) found almost correctly perceived inflation for the previous year (in contrast withhis previous study) but again under-estimated perceived inflation for the previous 15 years.It appears that people remember recent prices quite well, and incorrectly recall prices inprevious periods. The results concerning last-year perceived inflation support the idea that

questioning consumers about past prices should not refer to prices longer than a yearback.Brachinger (2008) assumes asymmetric inflation perceptions for price increases versus

price decreases. Due to the asymmetric value function in prospect theory (Tversky &Kahneman, 1991), price increases should influence perceptions more than price decreases.Hence, items associated with large price increases (e.g., for health services) should influ-ence general perceived inflation more heavily than items associated with minor priceincreases or price decreases (e.g., for telecommunication). This expectation may be qual-ified by distinguishing between absolute and relative price changes. For example, a onecent per minute price increase on telephone calls may be evaluated as quite high because

it is high when expressed as a percentage of the per minute price. In contrast, a one centincrease of gasoline prices may be evaluated as quite low (cf. Ranyard, Del Missier,Bonini, Duxbury, & Summers, 2008). Hoffmann, Leifer, and Lorenz (2006) seem to favorthe role of relative price changes in consumer price perception.

In addition to frequency of purchase, the type of payment may influence perceivedinflation. In general, out-of-pocket payments may influence consumer inflation percep-tions more than payments from bank accounts or credit cards (Davies & Lea, 1995).Out-of-pocket expenses may be experienced more vividly, whereas payments by standingorder or delayed payments may go relatively unnoticed.

Summarizing, consumption of items with high purchase frequency, high price increases,

and out-of-pocket payments may influence perceived inflation relatively strongly. Thesehypotheses may be tested by analyzing the effects of particular consumption categorieson perceived inflation, for example, food (high purchase frequency) versus furniture andappliances (low frequency), alcohol and tobacco (high price increases) versus clothing

G. Antonides / Journal of Economic Psychology 29 (2008) 417–432 419


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and footwear (low price increases), and alcohol and tobacco (out-of-pocket expenses) ver-sus housing, water and energy (payments by standing order).

2.1. Psychophysics

Psychophysical theory has developed quantified relationships between objective andsubjective stimuli, i.e., between actual and perceived price changes. Weber’s law impliesthat the ratio of the just noticeable price change, DP , and the reference price level, P ,should be a constant, C . That is, regardless of the price level, the price change that justcan be perceived is a constant fraction of the reference price.2

D P = P ¼ C ð1Þ

This implies that consumers who are aware of a 1% price change for a one-euro productshould also be aware of a 1% price change for a 10-euro product.

Fechner’s law not only applies to the perception threshold but also to price differencesin general. Fechner’s law implies that the ratio of a price change and the base price levelshould equal the perceived price change, dW

d P = P ¼ dW ð2Þ

The just noticeable perceived price change is considered the unit of the subjective scale,W. Eq. (2) implies that the sensation evoked by a price change is a constant fraction of theprice level. For example, the sensation magnitude evoked by a 10% price change for a one-euro product equals the sensation magnitude evoked by a 10% price change for a 10-euro

product, even when the perception threshold is only 1%. By integration of Eq. (2), Fech-ner’s law results in a logarithmic perception function of prices. This idea is consistent withthe common notion of consumers being ‘penny wise and pound foolish.’ In one version of this notion Tversky and Kahneman (1981) observed that subjects generally were not will-ing to drive 20 min to save $5 on a calculator costing $125. However, they were willing todrive 20 min to save $5 on a calculator costing $15. Thaler (1999) explains that this behav-iour reflects the psychophysical principle that the difference between $10 and $15 seemsbigger than the difference between $120 and $125, in accordance with the Weber–Fechnerlaw. This phenomenon is also called diminishing marginal sensitivity (cf. Tversky & Kahn-eman, 1991).

By way of comparison, Fechner’s law could be simplified to a difference model, imply-ing that a price change should equal the perceived price change, dW

d P ¼ dW ð3Þ

The difference model is inconsistent with diminishing marginal sensitivity (see also Hoff-mann et al., 2006).

Several authors have obtained results contradicting the Weber–Fechner law. For exam-ple, consumers perceive 15% changes better for a 55c product than for a 15c product (Uhl,1970). The probability of consumers changing to a 2c lower priced gasoline brand is higherif the price is 42c than if it is 28c, contradicting Fechner’s law, too ( Kamen & Toman,

1970). As an alternative, consumers may compare price offers to a ‘fair’ price. With a

2 Technically, the detection threshold corresponds to a stimulus change that is perceived with a probability of 50%.



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low ‘fair’ price, the consumers in the experiment above react adversely to a further priceincrease at 42c, whereas they are quite tolerant to an increase at 28c. Batchelor (1986),using perceived inflation data in different EU countries in different years, found that thenumber of units of the subjective scale associated with the subjective sensation of ‘moder-

ate inflation’ differed across countries and across different years which is inconsistent withFechner’s law.

Stevens’ law (1957) acknowledges that the just noticeable difference may not be con-stant in subjective size. Alternatively, Stevens’ law implies that the ratio of perceived pricechanges and the perceived reference price (dW/ W) should equal the ratio of price changesand the reference price (dP/P )

dW=W ¼ d P = P ð4Þ

Hence, by integrating Eq. (4), W is found to be a power function of P , similar to the well-

known Cobb–Douglas specification. We are not aware of a test of Stevens’ law in the areaof price perception.

The psychophysical equations have been tested with respect to specific sensations, e.g.,light of a particular frequency, brightness and saturation, sound of particular frequencyand amplitude, or the price of an ounce of gold. Although specific sensations may be stud-ied in the laboratory, in actual practice consumer sensations may be less specific. Forexample, the price of a pair of socks may depend on the brand, quality, and shop statingthe price. The consumer may form a subjective reference price at time 0, u(P 0), for the par-ticular item using some averaging mechanism, u (see Briesch, Krishnamurthi, Mazumdar,& Raj, 1997, for an overview of reference price construction models). Then, consumersmay mentally compare the actual purchase price at time t, P t, with the subjective referenceprice for past purchases and form a perception of price change for the particular item.They may then form an aggregate of perceived price changes for all items they consume.Obviously, consumers make different purchases, such that their experience with purchaseprices will vary. Consequently, in aggregating perceived item price changes, each consumermay use subjective item weights, di , for each item, i . For example, a consumer who neverbuys gasoline may give zero weight to gasoline price changes. Finally, consumers mayaggregate their perceptions over a large number of items to form perceptions of generalprice inflation, dW, as stated in Eq. (5)

dWt ¼ Riðdi P it =/ð P i0ÞÞ ð5Þ

Even if the process described above may not actually take place in consumer price judg-ments, this model may be used to explain the results of consumer judgments. Althoughindividual consumers have their own inflation perceptions, the aggregate of all perceptionsin the population may provide an unbiased indicator of perceived general price inflation,i.e., concerning all consumer items. This reasoning is similar to the ‘Law of large numbers’argument used by Katona (1975, p. 55), implying that ‘‘. . .what individuals will do isuncertain, but what hundreds or thousands of individuals will do is not equally uncertain”(Katona, 1979, p. 120). Likewise, the individual perception of inflation may be incorrect,

but the aggregate perceived inflation in a large sample may not be equally incorrect. Wewill investigate the association between aggregate perceived inflation and objective priceinflation, as measured by the price index.



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2.2. Price index

With respect to price inflation, usually a basket of goods is used to construct a Laspey-res price inflation index (Varian, 2005). The well-known harmonized consumer price index

(HCPI) in the European Union is based on the same basket of goods in all EU countriesand is constructed as a weighted average of a large number of ratios of observed prices, P it,of each good i included in the index at time t and observed prices at time 0, P i 0

CPIt ¼ Riðwi0 P it = P i0Þ ð6Þ

The weight, wi 0, represents the average budget share of expenditures on good i at thebase time 0, taken from consumer budget studies, such that the weights for all goodsadd up to one. This procedure stems from the idea that the more consumers spend on aparticular good, the higher the contribution of the good to the overall price index shouldbe. The budget shares are updated approximately every five years. The summation oper-

ator,P

, adds the weighted price changes over the total number of goods, I . In addition tothe overall price index, category price indices are constructed based on different baskets of goods, for example, all products categorized as transportation, including purchase of vehi-cles, operation of personal transport equipment, and passenger transport services. Fromthe price indices the price change ratios in Eq. (2) with respect to the previous 12 monthsare calculated as (CPItCPIt12)/CPIt12.

Since data regarding perceived reference prices (W) is non-existent, it is impossible toestimate Eq. (4). In our empirical research, we will estimate Eq. (2) by using perceivedinflation series and actual price change series. Also, we use Eq. (2) for estimating relation-ships between perceived inflation and price changes in a number of product categories.Since both item budget shares and item price changes determine the price index, perceivedinflation is also expected to be related to these factors. Our approach differs from earlierresearch because it is related to total consumption and consumption categories rather thansingle consumption items, and to opinions of the general public rather than individuals.

3. Data

Eurostat publishes monthly price indices based on observations of consumer productprices in each member country on their web site (see European Communities, 2004). In

addition to the general HCPI, we use Laspeyres price indices of twelve consumer goodscategories in the 1996–2006 time period, i.e., (1) food and soft drinks, (2) alcoholic drinksand tobacco, (3) clothing and shoes, (4) housing, water and energy, (5) furnishing andappliances, (6) health, (7) transportation, (8) communication, (9) recreation and culture,(10) education, (11) restaurants and hotels, and (12) miscellaneous. In addition, we useconsumer price indices from National Statistics UK for the 1988–2001 time period, fromtheir web site.3

An overview of price changes in these categories is shown in Table 1. The overall priceindex in the 25 EU countries has increased 14.5% from January 1996 until January 2002(on average 2.4% per annum). After the introduction of the euro on 1st January 2002, until

June 2006, prices have increased 10.3% (on average 2.3% per annum). Above-average price

3 Since in our analyses we converted price index figures to annual rates of change, the base level (100 in the year2005) is not relevant.



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increases have occurred in the categories of alcohol and tobacco, housing, health, trans-

portation, education, restaurants and hotels, and miscellaneous items.Since we will compare the price indices of the twelve item categories with overall infla-

tion perceptions, we use series of perceived inflation for the 1996–2006 period from Euro-stat. For the countries listed in Table 2, both series of perceived inflation and actual

Table 2Average perceived and average actual annual inflation in different EU countries (1996–2006) (Standard deviationbetween parentheses)

Perceived inflation Actual annual inflation

EU, 25 countries 20.67 (13.63) 2.52Belgium (BE) 32.33 (17.08) 2.03Denmark (DK) 22.55 (7.80) 2.23Estonia (EE) 32.75 (13.98) 6.56Finland (FI) 13.16 (12.76) 1.64

France (FR) 19.93 (24.88) 1.85Ireland (IE) 34.79 (19.80) 3.63Hungary (HU) 33.48 (15.41) 13.71Netherlands (NL) 33.73 (21.88) 2.67Portugal (PT) 33.15 (13.62) 3.22Slovenia (SL) 39.95 (12.84) 8.61Sweden (SE) 26.60 (6.90) 1.67United Kingdom (UK)a 15.76 (14.28) 3.78

a January 1988–December 2001; Correlation between perceived and actual inflation equals .43.

Table 1Annual price changes in 25 EU countries for twelve item categories

Item categories Euro countries a

January 1996–

December 2001

Euro countries a

January 2002–

June 2006

Non-euro countries b

January 1996–

December 2001

Non-euro countries b

January 2002–June

2006All items 1.86 2.25 4.38 2.93Food and drinks 2.73 0.84 3.75 1.67Alcohol and

tobacco3.77 4.82 8.00 3.26

Clothing andfootwear

0.06 1.46 0.28 1.79

Housing, waterand energy

2.21 3.99 6.32 5.45

Furnishing andappliances

1.36 1.07 2.28 0.44

Health 3.28 3.44 5.76 3.93Transport 1.84 3.88 4.78 4.61Communications 2.21 1.33 0.94 1.81Recreation and

culture0.64 0.21 3.20 1.00

Education 2.51 2.32 11.06 6.82Restaurants and

hotels2.73 2.96 7.42 4.62

Miscellaneous 1.97 2.45 5.04 3.31

a Belgium, Finland, France, Ireland, Netherlands, Portugal.b Denmark, Estonia, Hungary, Slovenia, Sweden, United Kingdom.



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category price changes were available. Perceived inflation was measured by asking about1500 consumers in each country in repeated monthly cross-section surveys the followingquestion:4 ‘‘How do you think that consumer prices have developed over the last 12months? They have. . .” The answers could be selected from the following categories:

‘‘Risen a lot,” ‘‘Risen moderately,” ‘‘Risen slightly,” ”Stayed about the same,” ‘‘Fallen,”and ‘‘Don’t know.” The answer percentages were used to construct a balanced scale as fol-lows: (%Risen a lot%Fallen) + ½ (%Risen moderately%Stayed about the same), leav-ing out %Risen slightly (the neutral point) and %Do not know.5 Only the balanced scalesare published on the Eurostat web site for a selected number of countries. For the UK (notincluded on the Eurostat web site) we obtained the answer percentage series directly fromEurostat for the period January 1988–December 2001; the balanced scale for the UK wascomputed from the percentage data. Since data for the UK comprise a different time per-iod than for the EU, the series cannot be compared directly.

The average and variation in the perceived inflation index, shown in Table 2, vary con-siderably across countries. In the Nordic countries, the average perceived inflation indexhas been negative, indicating that relatively many people thought prices had remainedthe same (or fallen) and relatively few people thought prices had risen slightly (or risena lot). Since prices in these countries generally had increased, negative perceived inflationimplies that price changes fell below the perceptual threshold, generally. In almost allcountries where inflation was above average, the perceived inflation index was also aboveaverage, indicating some validity of consumer perceptions.

The perceived inflation data refers to perceived price changes in the previous twelvemonths, allowing analysis of Eq. (2). However, using this data it is not possible to analyze

the perceived price level, for example in Stevens’ law.

4. Results

Fechner’s law implies a linear relationship between perceived inflation (perceived pricechange in the previous twelve months) and the rate of price change (ratio of price levelstwelve months apart). Time line charts of these variables are shown in Fig. 1 for the coun-tries selected. The apparently similar behavior of the two variables over time was con-firmed by the average correlation of 0.73 across countries (the average correlationbetween perceived inflation and the price level, not transformed into rate of price change,

was only 0.26; the average correlation between perceived inflation and the price difference,i.e., the difference between price levels twelve months apart, was 0.67.) This result providedsome evidence for Fechner’s law applied to inflation perception. Although the two vari-

4 Sample sizes differed in the following countries: Estonia (800), Finland (2200), France (3300), Portugal (2100),UK (2000). Sampling procedures varied across countries and were either random or stratified, then random,based on telephone directories or addresses. Samples were deemed representative within about 2% error aroundthe balanced statistics.5 The EU uses this coding schema for the entire consumer survey, including consumer sentiment data, perceived

inflation and other consumer opinions. The Michigan Survey Research Center uses a coding schema implying

equal weights of all positive and negative answers, thus treating extreme answers the same as less extremeanswers. The EU schema should result in larger variation of the coded answers, and possibly higher sensitivity toprice changes. It should be noticed, however that weighted answers should be interpreted with care. For example,a negative outcome may not longer be interpreted as indicating more people perceiving price decreases than priceincreases.



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ables should not be compared directly because they comprised different scales, they seemedto behave somewhat differently after the introduction of the euro in 2002 than before,especially in the euro zone.6 In Belgium, France and Portugal, the Netherlands and Irelandperceived inflation increased more than the rate of actual price change after the introduc-tion of the euro, although in the latter two countries the two variables seemed to behavelike normal again in 2006. These results differed from those obtained by Dziuda andMastrobuoni (2005) who studied differences between the standardized raw series of per-ceived and actual inflation, and Aucremanne, Collin, and Dhyne (2005) who transformedperceived inflation by dividing by the ratio of standard deviations of perceived and actualinflation series, i.e., not taking into account Fechner’s law.

-40

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Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Denmark, PI Denmark, RoC

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Belgium, P I Belgium, RoC

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Estonia, PI Estonia, RoC

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Finland, PI Finland, RoC

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Fig. 1. Perceived inflation (PI) and per thousand price change (RoC) in selected EU countries (1996–2006).

6 In order to fit perceived inflation and rate of price change in the same figure, the vertical axes in Fig. 1 refer tothe (weighted) difference between percentages in the case of perceived inflation, whereas they refer to perthousand change in the previous year in the case of price changes.



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Our first analysis was aimed at estimating the statistical relationships between perceivedand actual rate of inflation time-series in the EU countries selected. First we dealt withautocorrelation, structural changes and the pooling of cross-section and time-series data.

Perceived inflation was indicated by the weighted percentage of people believing thatprices have increased minus the weighted percentage believing that prices remained thesame or decreased in the past year, counting extreme answers twice as much as non-

extreme answers. Month-to-month changes in perceived inflation were expected to showconsiderable overlap, i.e., autocorrelation as indicated by the Durbin–Watson statisticin regression analysis. Hence, direct statistical analysis of the correlation between per-ceived and actual inflation rates would result in inefficient estimates. We have estimatedregression (7) of perceived inflation (PI) on the overall rate of price change (RoC) for eachcountry separately (with coefficients a0 and a1, and error term e). D–W statistics fell belowthe critical value of 0.6 in all cases, indicating positive autocorrelation, as expected.7

PIt ¼ a0 þ a1RoCt þ et ð7Þ

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Slovenia, PI Slovenia, RoC

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United Kingdom, PI United Kingdom, RoC

Fig. 1 (continued )

7 We also estimated ARIMA models with higher-order time lags. However, in neither country were the second-order and third-order lags significant, although occasionally a significant higher-order lag was observed. Sincefirst-order autocorrelation was very close to one, we decided to remove autocorrelation by taking first differencesrather than taking estimated autocorrelation into account.



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The same result was found in regressions including the 12-item category price changes.To remove first-order autocorrelation, we conducted linear regression (8) on first differ-ences without constant term.8

PIt PIt 1 ¼ a1ðRoCt RoCt 1Þ þ u

t ð8ÞStructural changes imply that statistical relationships are varying over time. For exam-

ple, the introduction of the euro might have changed consumer inflation perceptions inaddition to the real price changes. Structural changes may be detected by conductingChow-tests on the residuals of the regression before and after the introduction of the euro.If the Chow-tests are not significant, we can safely assume that the regression parametersare stable in the time period studied. For each country, we conducted regressions of per-ceived inflation on the 12-item category inflation series in first differences without constantterm. The regressions yielded D–W statistics close to 2, indicating negligible autocorrela-tion. Also, regressions were conducted for periods before and after the introduction of theeuro separately. The Chow-test was insignificant in all countries, indicating stability of theparameters over time. We also included dummy variables for time periods before, duringand after the introduction of the euro. However, the dummy variables were insignificant inregressions of overall price changes and also in regressions of individual item categoryprice changes for all countries, indicating that perceived inflation did not shift significantlyover time after taking into account the rate of price change.

The issue of pooling country data arises in the decision of whether to analyze statisticalrelationships for all countries together or for each country separately. We performedregression analyses of perceived inflation on the 12-item category price changes, in first dif-

ferences and without constant term (see Maddala, 1977). An F -test based on the residualsof pooled (all countries together) and non-pooled regressions (all countries separated) wasconducted to test for equality of the parameters across countries (F = 3.04, df 1 = 72,df 2 = 1183, p < .01). Since the F -test was significant, pooling was not allowed becauseparameters were likely to be different across countries.

Next, we consider the parameters estimated in the regressions. Table 3 shows the resultsof regressions of perceived inflation on the rate of change of the overall price index, bothtaken in first differences. For the EU as a whole, the Nordic countries, and the UK, therate of price change parameter was statistically significant, supporting Fechner’s law.However, in the other countries the rate of change parameter was not statistically signif-

icant. In all countries, the D–W statistic was close to 2, indicating that autocorrelation waseffectively removed by taking first differences.

Table 4 shows the results of regressions of perceived inflation on the rate of change of the item category prices, omitting non-significant coefficients. It appeared that in differentcountries different item categories were significant in explaining perceived inflation. Trans-port price changes were significant in explaining perceived inflation in the European Unionas a whole, Denmark, Finland, and Portugal. Health price changes were significant inexplaining perceived inflation in Denmark; miscellaneous items in Hungary and Slovenia;communication in the UK; restaurants in Slovenia. The education coefficient for the EUwas negative, possibly reflecting the fact that education prices mainly increased in the first

8 The first difference equation leaves the coefficient a1, capturing the relation between perceived inflation andrate of price change, unchanged. However, since (8) contains first differences, the results cannot be compareddirectly with the graphs in Fig. 1, showing the original variables of perceived inflation and rate of price change.



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month of each year, not in the other months. The recreation coefficient for Ireland wasnegative, indicating that overall perceived inflation moved in a direction opposite to thespecific rate of recreation price changes. The clothing coefficient was positive for Den-mark; however, for Belgium it was negative.

Table 4Regression results of perceived inflation on rates of change of item category price indices

Significant item categories Rate-of-change coefficient Adjusted R2 D–W coefficient

EU25 Transport 0.110 (2.732)**

0.166 1.857Education 0.237 (2.352)*

Belgium Clothing 0.039 (2.584)* 0.097 2.324Denmark Clothing 0.069 (3.173)** 0.096 2.481

Health 0.051 (2.037)*

Transport 0.107 (2.667)**

Estonia – – 0.040 2.186Finland Transport 0.104 (3.943)** 0.146 2.069France – – 0.022 1.985Hungary Miscellaneous 0.240 (2.716)** 0.017 2.307Ireland Recreation 0.228 (2.179)* 0.005 2.392Netherlands – – 0.062 1.882

Portugal Transport 0.234 (3.317)** 0.051 1.665Sweden – – 0.038 2.447Slovenia Restaurants 0.216 (2.229)* 0.073 2.602

Miscellaneous 0.222 (2.242)*

UKa Communication 0.641 (2.315)* 0.037 2.126

* p < .05.** p < .01.a January 1988–December 2001.

Table 3Regression results of perceived inflation on rate of change of overall price index in different EU countries

Rate-of-change coefficient R2 Durbin–Watson

EU25 0.422 (3.872)** 0.118 1.857

Belgium 0.121 (1.165) 0.012 2.389Denmark 0.277 (2.281)* 0.044 2.664Estonia 0.013 (0.198) 0.000 2.178Finland 0.384 (4.143)** 0.133 2.140France 0.152 (1.116) 0.011 1.941Hungary 0.085 (1.157) 0.012 2.329Ireland 0.171 (1.417) 0.018 2.381Netherlands 0.159 (1.131) 0.011 1.955Portugal 0.087 (0.744) 0.005 1.722Sweden 0.177 (2.204)* 0.042 2.361Slovenia 0.154 (1.352) 0.016 2.599

United Kingdom

a

1.833 (2.579)

*

0.041 2.176Absolute t-values between parentheses.* p < .05.

** p < .01.a January 1988–December 2001.



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The above reported regressions were based on the balanced perceived inflation indices,implying twice as much weight given to the price perception categories ‘‘Risen a lot ” and‘‘Fallen” than to the categories ‘‘Risen moderately” and ‘‘Stayed about the same.” For thisreason, the balanced scale was relatively sensitive to the extreme answer categories. Since

the raw percentage data were available for the UK, we also computed the balanced scalewith equal weights. The correlation between the balanced scale with equal weights and thebalanced scale with different weights was estimated at 0.998 (0.992 for the first-differencedseries), showing that different weights hardly made a difference in the resulting perceivedinflation index.

To test for the robustness of the balanced scale further, we computed correlationsbetween the balanced scale and the percentage answering ‘‘Risen a lot ” (r = 0.97), the totalpercentage answering ‘‘Risen a lot” and ‘‘Risen moderately” (r = 0.98) and the total per-centage answering ‘‘Risen a lot,” ‘‘Risen moderately” and ‘‘Risen slightly” (r = 0.93),which were available for the UK only. The correlations between the overall rate of changeand these percentages were, respectively, 0.90, 0.88 and 0.81, the correlation between over-all rate of change and the balanced scale was 0.90. Furthermore, the only rate of pricechange category that was significantly related with each of the inflation perception catego-ries was communication. As a conclusion, the balanced price perception scale seemed to bequite robust against different ways of combining answer categories.

Although diminishing sensitivity implies consumers to evaluate price changes in termsof relative percentage differences rather than absolute price differences, Gärling and Gam-ble (2008) found that consumers used both types of evaluation in forecasting future infla-tion. By way of comparison, we conducted regression (8) with the rate of change

substituted by price differences. For the single regressions by country and for the EU asa whole, the average R2 was 3.3% which was slightly lower than the average of 3.6%for the RoC regressions reported in Table 3. For the multiple regressions, the averageR2 for price differences was 5.1%, whereas for price ratios it was 7.2%. These figures sug-gest that perceived inflation was explained somewhat better from price ratios than fromprice differences.

5. Discussion

After removing substantial autocorrelation, significant correlations were found between

perceived inflation and the rate of price change in the EU as a whole and in a number of member countries, supporting Fechner’s law. This result differed from previous research inwhich relations between perceived inflation and the price level were investigated (e.g.,Aucremanne et al., 2005).

The introduction of the euro did not significantly affect the level of perceived inflation,given the actual inflation rate and after removing autocorrelation. However, in severalcountries perceived inflation first increased substantially, then returned to normal levelin 2006. Aucremanne et al. (2005) found a discrepancy between perceived inflation andprice level after the introduction of the euro in euro countries but not in non-euro coun-tries, suggesting that the introduction of the euro was responsible for the perception gap.

Because their inflation perception model differs from ours, these results cannot be com-pared directly, however.

It appeared that perceived inflation to some extent was explained by different itemcategory price changes in different countries, including transportation, communication,



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clothing, health and restaurants. Price changes in the categories of food and drinks, fur-nishing and appliances, did not significantly explain inflation perceptions in the selectedcountries, despite the substantial weight of these categories in the Laspeyres price index.This result suggests that consumers’ inflation perceptions are based on price changes of

highly selective consumption items, in contrast with the Laspeyres price index weightingprice changes by the consumers’ budget shares. Furthermore, consumer product categori-zations in different countries may differ from the harmonized product classifications usedin the EU price indices, thus leading to different item categories explaining perceived infla-tion across countries.

Explanations from the literature to some extent may support our findings. Frequency of purchase and out-of-pocket type of payments may have influenced inflation perceptions inthe area of transport and communication in several countries. In contrast, expenditures onfurnishing and appliances were not significantly related to inflation perception, possiblydue to their infrequent purchase. However, the overall effect of purchase frequency maybe relatively small (cf. Ranyard et al., 2008).

However, some results were puzzling and not fully in line with theoretical expecta-tions. Expenditures on food and soft drinks, alcohol and tobacco were not significantlyrelated to inflation perception, despite the frequency of purchase. Housing, water andenergy were not significantly related to inflation perception, despite their relatively highprice increases.

Difficulties in interpretation of the results were partly caused by the use of categoryprice indices, summarizing the information about individual product prices, thus prevent-ing analysis of price inflation for individual products. For example, the ‘frequency hypoth-

esis’ was hard to test on the category of hotels, pubs and restaurants since hotel expensesmay be less frequent than expenses on pubs. This result may also indicate that the per-ceived inflation model stated in Eq. (5) does not work well with the item categories inthe EU statistics. Future research may be focused on product prices and price perceptionsof individual purchases, taking into account economic-psychological product classifica-tions such as reference price availability in memory, type of payment, discretionary versusnon-discretionary consumption, etc. Such research may also avoid the problem of relatingperceptions of non-buyers to observed price changes of non-purchased goods (cf. DelGiovane & Sabbatini, 2005).

Several policy implications of our results exist. The consumer price index is based on

category price changes weighted by budget shares, whereas perceived inflation appearsto be associated with price changes in a limited number of item categories. Hence, the cred-ibility of monetary policy based on statistical price indices can be called into question (DelGiovane & Sabbatini, 2005). Several categories with high budget shares did not seem toaffect perceived inflation at all. In order to influence consumer spending, the determinantsof perceived inflation should be taken into account. In several countries, this implies aprice policy focusing on transportation.

Acknowledgement

We thank Fergus Bolger and Manon de Groot for their comments on a previous ver-sion of the manuscript.



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How is Perceived Inﬂation Related to Actual Price Changes in the European Union

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