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
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
Objectives & Core Topics
This term paper examines the discrepancy between official inflation rates and the inflation perceived by the public following the introduction of the Euro in 2002. It investigates Wolfgang Brachinger's theoretical model, the Index of Perceived Inflation (IPI), and subjects it to a rigorous academic critique based on behavioral economics and empirical data.
- Theoretical foundations of Prospect Theory (Reference dependency and Loss aversion).
- Technical derivation of the Index of Perceived Inflation (IPI).
- Critical analysis of model assumptions vs. empirical observations.
- Comparison between the IPI and the European Consumer Survey results.
- Evaluation of non-currency factors influencing price perception.
Excerpt from the Book
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. 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. 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. 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:
Summary of Chapters
1. Introduction: Discusses the puzzling gap between official Euro-zone inflation metrics and public perception following the 2002 currency changeover, setting the paper's aim to analyze Brachinger’s IPI model.
2. Methodology: Outlines the paper's structure, focusing on the examination of Prospect Theory, the mechanics of the IPI, and a critical empirical review of the results.
3. A brief Introduction to Prospect Theory: Explains the psychological concepts of reference dependency and loss aversion that form the backbone of Brachinger's approach.
4. Brachingers Index of Perceived Inflation (IPI): Details the mathematical derivation of the IPI from Laspeyres index formulas and how it incorporates purchasing frequency weights.
5. Criticism on Index of Perceived Inflation (IPI): Provides a comprehensive critique of the model's assumptions, questioning their empirical validity and comparing them against the European Consumer Survey.
6. Results and Conclusion: Summarizes findings, concluding that the IPI model does not provide a robust empirical explanation for perceived inflation and is outperformed by broader economic and psychological interpretations.
Keywords
Perceived Inflation, Euro, Brachinger, Prospect Theory, Loss Aversion, Reference Dependency, Consumer Price Index, CPI, Purchasing Frequency, Behavioral Economics, Currency Changeover, Teuro, Inflation Perception, Consumer Survey, Price Sensitivity.
Frequently Asked Questions
What is the central focus of this term paper?
The paper focuses on understanding and critically evaluating the "Index of Perceived Inflation" (IPI) developed by Professor Wolfgang Brachinger in response to the public's perception of "Euro inflation."
Which theoretical framework does the author use to analyze inflation perception?
The author utilizes Kahneman and Tversky’s "Prospect Theory," specifically focusing on reference dependency and loss aversion to explain why consumers perceive price changes differently than standard economic indicators suggest.
What is the primary research goal?
The goal is to determine if Brachinger's IPI model is a suitable and empirically supported method for quantifying the phenomenon of perceived inflation compared to the official Consumer Price Index.
Which scientific methodology is applied?
The paper uses an analytical approach that deconstructs the mathematical formulas behind the IPI, compares them with empirical data from the European Consumer Survey, and critiques the behavioral assumptions used in the model.
What topics are covered in the main section of the paper?
The main sections cover the basics of Prospect Theory, the derivation of the IPI, an extensive critique of its assumptions (such as constant loss aversion), and alternative explanations for perceived inflation, including tax changes and service price increases.
Which keywords characterize this academic work?
Key terms include Perceived Inflation, Prospect Theory, Loss Aversion, Reference Dependency, and the Euro currency changeover.
Why does the author claim that the IPI model might be flawed?
The author argues that the IPI relies on unrealistic simplifications, such as the assumption that loss aversion is identical across all goods and consumers, and fails to account for "diminishing sensitivity" to price changes.
Does the paper conclude that the IPI successfully explains the "Euro-inflation"?
No, the paper concludes that the IPI is not suitable for explaining the high levels of perceived inflation, suggesting instead that factors like individual budget impact and media-driven price awareness are more significant.
- Quote paper
- Sebastian Sturm (Author), Robert Helbig (Author), 2007, Perceived inflation , Munich, GRIN Verlag, https://www.grin.com/document/72467
