Discussion Paper                                                              No. 24  June 14, 2011Perceived inflation af...
relationship between perceived and expected inflation in Estonia, which might indicate the in-direct relationship between ...
1. Introduction                                                                                                          T...
4(e.g., currency changeover). In sum, one may divide the relevant literatureinto three groups. The first group deals with ...
According to Cecchetti (1985, 1986), the average time between pricechanges of magazines in the US was approximately 7 year...
3. The presence of a shock: how does euro cash change-over affect prices?Another important question is how often and wheth...
In addition to the one-off costs, there are factors that may give rise to one-offor permanent increase in prices. The main...
retailers may not change prices (according to changes in costs) on a currentbasis, but do so less frequently, until a new,...
It has been found that the subjective value of a currency is influenced by an        Perceptions are affected             ...
money is an important parameter of national identity, the southern Europeancountries seem to express it more through cultu...
Another example includes the undue influence of sunk costs and the                                                        ...
that most of the benefits are expected to accrue to those in finance andbusiness; and (b) instead of a national currency w...
45                                     46organization” approach      and “innovation-diffusion theory”     say thatcommuni...
rate perceived by the general public. All in all, this estimation procedure de-pends on several assumptions, the plausibil...
Euro area actual and perceived inflation rate (in percent)5%           HICP, yoy           perceived inflation, yoy4%3%2%1...
case, the difference between quantified perceived and actual inflation is sta-tionary. This means that there has been a no...
ceptions in so many countries. The relationship between monthly changes inexpectations and monthly changes in inflation pe...
experience of other euro area countries. It might happen that increases inprices in certain fields (e.g., electricity and ...
tags (menu costs), IT costs, the need for larger amounts of cash during theperiod of parallel circulation, etc. The transf...
References:     1. Aucremanne, L.; Collin, M., Stragier, T; “Assessing the Gap Be-         tween Observed and Perceived In...
17. Clarida, R., Gali, J., Gertler, M., "The science of monetary policy: a        New Keynesian perspective", Journal of E...
38. Northcraft, G. B.; and Neale, M. A.; “Experts, amateurs and real         estate: An anchoring and adjustment perspecti...
Appendix 1Table 1. Unit root tests at the country level                                                                   ...
Table 2. Results of the Granger causality testsInflation does not Granger cause inflation expectations                    ...
Inflation expectations does not Granger cause inflationperceptions                                                        ...
Discussion Paper, No. 24 - June 14, 2011
Discussion Paper, No. 24 - June 14, 2011
Discussion Paper, No. 24 - June 14, 2011
Discussion Paper, No. 24 - June 14, 2011
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Discussion Paper, No. 24 - June 14, 2011: Perceived inflation after euro cash changeover: the case of Estonia

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Discussion Paper, No. 24 - June 14, 2011

  1. 1. Discussion Paper No. 24  June 14, 2011Perceived inflation after euro cash changeover:the case of EstoniaThe adoption of euro has been accompanied by a larger increase in inflation perceptions thanactual inflation developments. The wedge between those two has widened right after theadoption of euro in all euro area countries. On one hand, the explanation of the gap betweenactual and perceived inflation is related to the measuring of those rates – the indices reflectprice changes differently. On the other hand, there is a bulk of ideas and theories related tothe consumers’ ability to adapt new value of exchange: the attitude towards new currency, therole of conversion rates, and the divergence of consumer baskets just to name a few.In this paper we analyse price movements in time of the shock – adoption of new currency.We start by explaining the overall price changes and then turn to the price change after ashock like change in value of exchange occurs. In the literature prices tend to be rather stickyduring the stable economic development – the changes in prices occur only once a year onaverage. The currency changeover might influence the price level via costs – firms are facingdifferent costs during the currency changeover, like the need to change price tags, related ITcosts, the need to have an extra amount of cash during the time of the parallel circulation etc.The transfer of these costs into the consumer prices depends on the firms’ pricing strategiesas well as on the overall competition level in the sector. In addition, price changes may stemfrom the marketing strategies (for instance, psychological pricing).Even though the prices may be calculated correctly people tend to perceive higher pricescompared to those in the national currency. In this paper we analyse different psychologicalfactors that influence the perception of prices, like the way people learn, memorise or identifythemselves or how they feel about the new currency. People tend, for example, calculateprices in euros back into national currency although the new currency has been in circulationfor some time. The comparison with prices in national currency that was valid more than sixmonths ago may be one of the causes behind the wedge between the actual and perceivedinflation.In the empirical analysis we use data on euro area and EU countries and add some non-euroarea countries as a control group. We find the relationship between actual and perceived infla-tion to be stationary before 2002 (the first wave of euro adoption), which indicates that peopletend to perceive price changes rationally. After euro adoption the picture changed somewhat.The gap persisted until 2008 when both started to move similarly again in most countries. Weconclude that the gap between perceived and actual inflation persisted for some years andwithin time disappeared again. We also analyse the causality between actual and perceivedinflation rate using Granger causality test. The tests however will not show the magnitude ordirection of the influence that people’s perceptions may have on actual and/or expected infla-tion, but show how much information one variable has to explain the other. Test results showthat the changes in perceived inflation may explain the changes in actual inflation in only fewcountries (Ireland, the Netherlands, Sweden, and Slovenia). At the same time, we find strong Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000. E-mail: ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher: Cecilia Hermansson, +46-8-5859 1588. Annika Paabut, +372 6 135 440. Elina Allikalt, +372 6 131 989.
  2. 2. relationship between perceived and expected inflation in Estonia, which might indicate the in-direct relationship between perceptions and actual rate of change of prices.Annika PaabutActing Chief Economist at Swedbank EstoniaContents: Page:1. Introduction 32. Price changes before and after euro cash changeover: price do change... 43. The presence of a shock: how does euro cash changeover affect prices? 64. Inflation perception - psychological factors behind it 85. Inflation perception, expectations, and actual inflation in euro area countries aftereuro adoption 136. What will it be for Estonia? Short discussion of the Estonian case 177. Conclusion 182 Discussion Paper No.24  June 14, 2011
  3. 3. 1. Introduction The way people perceiveIn modern economic theory, the role of information has been central in de- inflation may have realscribing factors behind aggregate fluctuations and business cycles. This is effectsespecially pronounced after Lucas’s (1973) work on anticipated and unan-ticipated shocks, after which it was widely accepted that information process-ing influences expectations formation at the individual level and thus affectsthe aggregate level as well. In recent years, the discussion on inflation ex-pectations and inflation perception has been widespread and has focused oninflation perceptions after a currency changeover. In many cases, the eurocash changeover is associated with the so-called nimbus of price increase,and therefore it is thought that it might undermine the credibility of officialprice measures and/or adversely influence public opinion about the new cur-rency. In addition, perceived inflation may have real effects. For example, ifconsumers’ overestimation of inflation results in an underestimation of theirpurchasing power, this might cause suboptimal consumption decisions.1 Stix(2006) shows that many results of experimental studies support this hy-pothesis, indicating that, if consumers feel that prices have grown, they willcut back on consumption. In addition, perception may carry over to expecta-tions. The experience of Austria2 shows that, until the end of 1999, inflationexpectations were slightly lower than perceived inflation; from 2000 to 2002,both rates were almost identical. However, the picture changed after Austriaadopted the euro in 2002. Perceived inflation was approximately 1.5 per-centage points higher on average until 2003, after which expected inflationwas revised significantly upwards (both expected and perceived inflationswere brought together). Expectations play impor-In economic theory, inflation expectations have an important role to play. Ac- tant role in economiccording to Phelps’s and Friedman’s work on the augmented Phillips curve, theoryexpected inflation is one of the most important determinants of actual infla-tion.3 Friedman (1968) said that the Phillips curve relationship is valid only inshort run - in the long run economic agents will take inflation into account.That means that the wages will increase in accordance with anticipated infla-tion. So, he states that in the long run the relationship between inflation andunemployment disappears. More recent studies on Phillips curve (see for in-stance Clarida et al (1999) and Blanchard and Gali (2007)) are related to theNew Keynesian dynamic stochastic general equilibrium models, where theprices are assumed to be sticky. Like the expectations augmented Phillipscurve, the New Keynesian framework also states that the relationship be-tween inflation and unemployment is temporary and increased inflation mayreduce unemployment only in the short run, but not permanently.Real business cycle theory says that, according to the theory of the naturalrate, the magnitude of a change in actual inflation is determined by the ex-pected inflation rate. And therefore, in the case of perfectly rational expecta-tions and without systemic forecasting errors, only unanticipated changes ininflation will affect real variables like output and unemployment.Many papers have found that the wedge between perceived and actual pricechanges has widened in the euro area, especially after the introduction ofeuro banknotes and coins; at the same time, the newest papers show that innonexceptional circumstances people perceive inflation rationally and theirperceptions and expectations become exaggerated in the case of shock1 ECB (2002), „Recent Developments in Consumer Inflation Perception“, Monthly Bulletin, July; pp 18-19.2 Fluch & Stix (2005).3 For details see Friedman (1968), Phelps (1967).Discussion Paper No. 24  June 14, 2011 3
  4. 4. 4(e.g., currency changeover). In sum, one may divide the relevant literatureinto three groups. The first group deals with consumers’ perception of pricesof the most frequently purchased goods and services.5 The second group ofpapers examines the individuals’ reaction to price increases and decreases– according to the hypothesis, people react more to price increases than de-creases.6 And the third group of papers7 studies experimental psychology,i.e., mechanisms that may influence people’s inflation perceptions after euroadoption.Inflation perceptions, expectations and actual inflation in euro area(EA12)5% 100 Perceived inflation (r.s.) Expected inflation (r.s.)4% Actual inflation (HICP, l.s.) 803% 602% 401% 200% 0 Source: ECFIN, Eurostat-1% -20 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11In this paper, we first briefly discuss the reasons why prices change during acurrency changeover. The third chapter deals with inflation perception andthe psychological factors behind it during euro adoption. Then we discussprice perception, expectations and actual inflation after euro cash change-over in euro area countries (the analysis covers period from 1997 (or laterdepending on the data availability) till 2010). And we conclude with a shortdiscussion on the Estonian case. As Estonia has adopted the euro only quiterecently (in January 2011), we do not have enough data for a deep analysisof cash changeover effects on inflation and inflation perception in Estonia.2. Price changes before and after euro cash changeover:prices do change...As Taylor (1999) points out, prices of final goods in customer markets seem Price changes stem forto be more responsive to changes in the costs of intermediate inputs to pro- different reasonsduction than they are to changes in demand. Or, put differently, changes incosts seem to be more the reason that prices change than changes inmarkups. However, even in so-called customer markets, prices can changequite rapidly – for, instance, the price of an airline ticket changes on a day-to-day basis, and some of the tickets are even auctioned on the Internet. Atthe same time, some other prices stay at the same level for years.4 Jemec (2010).5 See Brachinger (2006), Stix (2006)6 See, for instance, Del Giovane and Sabbatini’s (2005) study for Italy; Deutsche Bundesbank (2004) for Germany;, and Banque Nationale de Belgique (2002)for Belgium.7 See, for instance, Marques and Dehaene (2004), Traut-Mattausch et al. (2004).4 Discussion Paper No.24  June 14, 2011
  5. 5. According to Cecchetti (1985, 1986), the average time between pricechanges of magazines in the US was approximately 7 years, during rela-tively low inflation in the 1950s, and 3 years, during the era of relatively highinflation in the 1970s.8 Carlton (1986) analysed manufacturing firms in theUS and found that the time between price changes varies from 1½ years forsteel and chemicals to ½ year for plywood and nonferrous metals. Thismeans that pricing behaviour differs among industries. Blinder (1994) andBlinder et al 1998) confirm the findings of Carlton (1989) and Cecchetti(1986). In his work, Blinder (1994) found that the time between price adjust-ments is one year: approximately 40% of firms change their prices once peryear, 10% change prices more frequently than once per year, and the re-maining 50% leave their prices unchanged for more than a year.In the more recent study of Bils and Klenow (2004), the results differ sub-stantially – they find much more frequent price changes, with half of theprices lasting only 4.3 months; if they exclude temporary price cuts (sales),they find that half of the prices last 5.5 months or less. Another importantimplication of their work is that the frequency of price changes differsdramatically across goods (their study covers 350 categories of goods andservices, which is about 70 percent of consumer spending and was basedon unpublished data from the Bureau of Labour Statistics for 1995-1997).For instance, some prices seldom change: prices of newspapers, men’shaircuts, and taxi fares change in fewer than 5% of the months covered. But,at the same time, some prices change very frequently, with prices ofgasoline, tomatoes, and air fares changing in more than 70 % of themonths.9According to Cecchetti (1986), who studied newsstand prices of 38 Ameri-can magazines over 1953-1979, the time between price changes varied from1.8 to 14 years. However, Bils and Klenow (2004) find that magazines(including subscription as well as newsstand prices) exhibit price changes onaverage every 11 months. And, more important, magazines prices are at thestickiest end of the spectrum, i.e., 86% of nonhousing goods prices changemore frequently.10The other branch of rather sticky prices is the prices of meals in restaurants. 11According to different studies, restaurant prices are the stickiest. But, inthe case of shocks (such as the euro cash changeover) these prices tend toincrease more than in other sectors, since entrepreneurs will try at leastsome time to postpone the price increase.The pricing behaviour of Estonian enterprises is quite similar to the price-setting behaviour of entrepreneurs in the euro area: on average, Estonianentrepreneurs change the prices of their main product/service once peryear.12Recall from university economics lectures – prices do change and thechange is affected by different factors. For instance, if prices of inputsincrease, then there is a high probability that prices of final goods/serviceswill increase as well. In addition, changes in prices are influenced bymacroeconomic conditions, sectoral conditions (cost structure or degree ofcompetition), time factors (like seasonality), and specific shocks (like value-added tax (VAT) changes, euro cash changeover, etc).8 As we can see down the line, the group of goods analysed by Cecchetti can affect this result.9 Bils and Klenow (2004).10 Bils and Klenow (2004), p 954.11 See, for instance, Hobijn et al (2004); Gaiotti and Lippi (2005), Bils and Klenow (2004), etc.12 Randveer and Dabušinskas (2006).Discussion Paper No. 24  June 14, 2011 5
  6. 6. 3. The presence of a shock: how does euro cash change-over affect prices?Another important question is how often and whether these changes in input Change in value of ex-prices, macroeconomic conditions, etc. will affect pricing behaviour of firms. change may have hadIn the relevant literature, it has been found that the speed of this adjustment effect on pricesis to a large extent determined by the beliefs of the entrepreneurs – ifentrepreneurs believe that the change in input prices is temporary, and thenthe price of their product will not change. But what about price changes incase of the shocks like a currency changeover? According to Eurostat(2003) approximately 50% of goods prices followed the usual path of changein 2001-2002, 20% of goods prices increased mostly due to other factors(e.g., tax changes, bad weather conditions, which ended up as poor har-vests in those years, etc.). The euro cash changeover in 2002 probably hadan impact on the prices of approximately 26% of goods groups.13 The priceincrease was most apparent in the case of restaurants and cafés, andhairdressers and beauty parlours, i.e., mainly locally provided services.Price increases in euro area (EA12) by different goods groups alcohol and tobacco8% food hairdresser HICP restaurants and cafes6% newspapers, books4%2%0% Source: Eurostat 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11There are several reasons why a slight price increase accompanies the cur-rency changeover; they mostly depend on how well an average companycan manage expenses arising from the changeover.From economic theory, we know that in the case of perfect competition, Price changes dependwhere the price equals marginal cost, fixed costs would not affect prices at on the level of competi-all. On the other hand, where the company’s pricing strategy rests on ex- tion and firms pricingpenses, prices may temporarily increase. After writing off the expenses, the strategycompany should return to the previous price level. Other countries’ experi-ence shows that the related extent of the price increase depends on thestrength of competition in trade. The price increase appeared to be smallerin smaller shops and in those countries where retail trade concentration waslower. A temporary price pressure may follow, depending upon the firms’pricing strategies, but there is no reason for prices to rise in the long run.The main expenses that retail companies must defray due to the euro cash There are fixed one-timechangeover are tied to price developments and replacement of price tags, costs related to thetraining of employees, accounting in several currencies during the period of change in currencyparallel circulation, and, when necessary, purchases of new software.1413 See also Lättemäe (2005).14 Lättemäe (2005).6 Discussion Paper No.24  June 14, 2011
  7. 7. In addition to the one-off costs, there are factors that may give rise to one-offor permanent increase in prices. The main reasons for a temporary price in-crease in case of the currency changeover are menu costs, money illusion,other expenses directly related to the changeover, and psychological pricing.Menu costs are defined as costs directly related to the price change process, Menu costs are directlysuch as, in the case of currency changeover, the development of new prices, related to the priceprinting of price tags, and remuneration of extra working hours etc. As men- change process such astioned above, many firms change prices more often than once a year, but a printing price tags, remu-regular price change might be postponed and timed for the changeover pe- neration of extra workingriod. Thus, the menu costs directly related to the changeover in fact should hours etcdecrease costs for the firm, but consumers perceive this as a price changedue to the currency change. Such a pricing strategy is definitely trickier toimplement when the media and public at large take more interest in the pricechanges.Money illusion is a bias in the assessment of the real value of transactions, People tend to observeinduced by their nominal representations.15 In other words, money illusion prices in nominal valuesdescribes the phenomenon that people tend to observe nominal values,since the nominal value of money is salient and a natural unit: the price islow, when the nominal value of the good is low. Furthermore, money illusioninfluences international trade and tourism, or, as Fisher (1928) said: “almosteveryone is subject to the ‘money illusion’ in respect to his own country’scurrency. This seems to him to be stationary while the money of other coun-tries seems to change”16There are also other expenses directly related to the euro cash changeover Firms need to spend onthat retail companies and services providers bear additionally to direct costs. training their employees,One may point to IT costs as one of the largest expense items. For instance, convert IT programs etc.during the period of parallel circulation, software should be developed to al-low accounting in two currencies. The impact of this kind of costs transfer tothe prices of goods/services will depend on the strategy firms use – if firmwants to depreciate the costs within a very short time period, the pricesmight increase in the short run, but if the software development is countedas long-term investment, then its effect on prices is almost negligible. At thesame time, additional costs may arise from the need to hold a larger supplyof cash because enterprises are directly involved in the withdrawal of cur-rency from circulation during the period of parallel circulation.17 This, in turn,increases the running operating costs over a short period. Another type ofcost is the cost of training of personnel (getting to know the new currency,managing cash in the period of parallel circulation, becoming acquaintedwith new software, etc.). In sum, relying on the experience of the adoption ofthe euro in 2002, these other direct costs related to the cash changeovermay be passed on to prices in the long run.Psychological pricing is a modern marketing tool based on the theory of con- Price changes may besumer psychology that, given the wide variety of goods, consumers cannot triggered by marketingpossibly remember or compare all prices. The main assumption behind psy- policy of a firmchological pricing is that consumers tend to ignore the last numbers on theprice tags in order to simplify price comparisons, rather than rounding themto the correct number. If consumers ignore the last numbers on price tags,the merchant gains maximum profit for prices ending with “nine”. Thus, ac-cording to psychological pricing, growth in demand is higher if the pricedrops by one euro from EUR 100 to EUR 99, as opposed to cases where theprice is lowered from EUR 99 to EUR 98 or from EUR 101 to EUR 100. So,15 Shafir et al. (1997), p 366.16 As former Israeli foreign minister Abba Eban remarked (in jest) at a time when Israel was experiencing three-digit inflation: “the dollar is an extremelyunstable currency: one month it’s worth 100 Israeli pounds, the next month it’s worth 200.”17 During the parallel circulation period, merchants and services providers accept euros as well as the national currency whereas, whenever possible, theyshould return the change in euros only.Discussion Paper No. 24  June 14, 2011 7
  8. 8. retailers may not change prices (according to changes in costs) on a currentbasis, but do so less frequently, until a new, attractive price is attained.There might also be a reverse psychological impact: the price ending with“nine” is linked mainly to something cheap, and the price ending with a zeroindicates something expensive; therefore, in the case of luxury goods, pricesending in a zero might prove more suitable.Thus, in sum, the price changes that might come from the changeover are The transfer of those oneassociated with imperfect markets and consumers’ irrational behaviour. If time increases in costsmarkets’ operations were optimal and consumers behaved rationally, there into consumer prices iswould be no need to worry that the changeover might cause inflation. Under affected by the imperfec-perfect competition, any firm trying to raise prices would lose its market tion of the marketsshare, while their expenses would not allow them to decrease prices either.Similarly, monopolies need not change prices as their price optimum in eu-ros and in national currency are equal, ceteris paribus.Now let us turn to consumers or, more precisely, how consumers feel aboutprice changes and what are the main factors behind the change in percep-tions in times of currency changeover.4. Inflation perception - psychological factors behind itIt is well known that people might perceive inflation differently from that There is no average con-measured by the consumer price index. Many authors have assumed that sumerperceived inflation is positively correlated with price increases of frequentlypurchased goods.18 The magnitude of perceived inflation is, in addition to thefrequency of purchases, influenced by different psychological factors. Andthese are especially important in the case of currency changeover.Since the euro cash changeover, there has been a difference in the percep- Getting to know new cur-tion of wages paid in euros and the perception of wages paid in the national rency depends how wecurrency that was previously in circulation. On the one hand, nominal values perceive the new valueof both currencies are different and this could affect the perception of prices of exchangeand wages. But, on the other hand, there was not only a change in thenominal value of money – the whole system was changed from a national tosingle currency system. This kind of loss of national autonomy and increasein interdependence with other countries could have influenced the attitudetowards the euro, and this attitude, in turn, affected the perception of wagesand prices.The introduction of the euro is associated with the following differentfactors:19 (a) the symbolic meaning of money; (b) how people learn,memorize, and process information; (c) how people judge and makedecisions; (d) what are the current expectations, concerns, and beliefs ofcitizens (consumers); and (e) how attitudes are changed by propaganda andcommunication.Symbolic meaning of money. The introduction of a new currency is much National currency hasmore than a change from one unit to another. For example, a national two meanings: symboliccurrency has two meanings: symbolic and economic. The best way to see and economicthis, is to look at the physical appearance of a coin – first meaning, as isusually shown on one side of the coin, expresses the symbols of authorityand legitimacy of the currency and, at the same time, national sovereignty.On the other side of the coin one can find the value of that particular “unit ofexchange” in economic transactions. These two sides are very intimatelyconnected.18 ECB (2002).19 Burgoyne et al. (1999).8 Discussion Paper No.24  June 14, 2011
  9. 9. It has been found that the subjective value of a currency is influenced by an Perceptions are affected 20individual’s net income and attitudes towards currency. But there is also by the attitude towardsevidence that people remember the inflation rate and use these memories in currencybuilding their attitude towards the currency. For instance, in Poland peoplederived greater appreciation from winning a prize in new zlotys than in oldzlotys. The latter was, in people’s minds, associated with high inflation. Afterthe introduction of the new zloty, people no longer preferred dollars – thenew zloty was much more stable than the old zloty. This means that theattractiveness of the money is determined by the attitudes of individuals.Nonetheless, the difficulties of getting public acceptance and trust are likelyto be compounded in the case of the euro, where all aspects of the unit ofcurrency will change: its physical appearance, its name, its value and itsvarious denominations.21 There will also be very few aspects of“associability” connecting the old currency to the euro. With the newcurrency, public understanding may be aided if links are drawn withexchange rates to other relatively familiar currencies. For instance, if theeuro had been adopted in the UK, it would have been worth approximately70 pennies. 22 In that case, a conversion to dollars may be helpful. It shouldbe noted that elderly people, in particular, tend to persist in having significantdifficulties converting to the new money.Learning, memorizing, and processing information. People’s opinion about The way we learn affectstheir ways of gathering and processing information, may be wrong as stated our perception of the in-in Burgoyne et al. (1999).23 For instance, one may think that repeating is flation after the currencynecessary in order to learn something. In some cases, this is true (e.g., re- in circulation hasmembering telephone numbers); however, if a huge amount of numbers is changedinvolved, this cannot be true – we live in era when everyone has severalpasswords, PINs to remember and it is hard (or even impossible) to remem-ber the prices of goods in one’s personal consumer basket. If there is a needto educate the public, it seems useful to look for some insights from cognitivepsychology as suggested in Burgoyne et al. (1999) to identify how people 24learn, process, represent, remember, and retrieve information. To sum up,one may say that the relevant information should be presented in a way thatis compatible with people’s existing habits and schemata (organised bodiesof knowledge).25In the context of currency exchange, the perfect example is given in the cur- Authorities have had dif-rency change in the UK in 1971, when decimal currency was introduced. For ferent approaches inassessing public’s needs for information to decimalisation there were used helping people to get ac-different types of psychological theories – the psychology of memory and the customed with new cur-psychology of learning. The main aim of the informational campaign which rencywas directed to the general public was concentrated in the two-month run-upto D-Day (the official date of transfer to decimalisation). This kind of gradual,ordered approach to the introduction of a new currency may be very helpfulin addressing the public’s needs.26It is well known that the perception of a currency is widely influenced by Attitude towards the cur-people’s attitudes towards the currency. In southern European countries, rency matters...e.g., Italy, Spain, and Greece, the attitude towards the euro waspredominantly positive, while the attitude in northern-central countries suchas the Netherlands, the UK, and Germany was more reserved.27 Since20 Brandstätter and Brandstätter (1996).21 Burgoyne et al. (1999).22 Ibid .23 Ibid .24 Ibid.25 Burgoyne et al (1999).26 Ibid.27 Pepermans and Verleye (1998).Discussion Paper No. 24  June 14, 2011 9
  10. 10. money is an important parameter of national identity, the southern Europeancountries seem to express it more through cultural and historicalachievements, while northern-central countries place their pride in theirnational economic situations.28 These attitudes could be seen to agree withsocial identity theory, according to which nations define their social identitythrough dimensions in which they fare better than others. This might help usto understand why those countries that are prouder of their culture andhistory than their economic situation are more likely to favour the euro. Onecan assume that the introduction of a single currency does not jeopardisetheir national identity and self-esteem. Meanwhile, countries that define theirnational identity through economic factors may fear that, with the introductionof a single currency, they will lose their national identity.In northern-central countries, national currencies, as constituent parts of their There are cultural differ-social identity, arouse feelings of commitment and emotional attachment. For ences in forming percep-Germany, for example, the deutsche mark (DM) was an important national tionssymbol, standing for a successful history of currency stability, a high reputa-tion in foreign countries, and rising and stable prosperity in Germany. TheGerman people’s identity and self-esteem have been, and still are, tightly in-terrelated with the country’s economic success and the deutsche mark,which represent the positive aspects of German history. National identity inGermany goes hand in hand with economic identity, which, in turn, providesthe perception of a positive distinctiveness in comparison with othernations.29Judgement and decision making. Even if people wish to use all the People are not alwaysinformation available to them, they are not able to do so because of rational“bounded rationality.”30 Irrespective of whether people perceive, judge,estimate, learn, or remember, they are unlikely to be able to take account ofall the information available in an accurate way and then combine it in themost rational manner to reach an optimal solution. Instead, people observethe way information is served (the “framing effects”) and compare that withother aspects of information presented at that time, including the channel ofcommunication (the “context effect”).In the case of a currency changeover, the information people do needconcerns the price level change. A potential problem for accepting a newcurrency involves the above- mentioned “money illusion.” Most of theeconomic transactions are represented in nominal terms, and, therefore, itseems likely that people often perceive and think about economic problemsin nominal terms, which may induce a "money illusion".People could make the right decisions if there were no inflation, which is adisorienting factor.31On this account, one might think that the elimination ofinflation should eliminate "money illusion" and regenerate rational behaviour.However, since "money illusion" affects wage cuts and nominal prices inseparate ways, the effects of "money illusion" are likely to extend tononinflationary settings.32In Shafir et al (1997) show that in recent research in cognitive psychologythe different representations of the same situation may lead to systematicallydifferent outcomes. For example, a choice between risky prospects may berepresented either in term of gains or losses, which seems natural to mostpeople, or in terms of final assets, as recommended by normative theory.3328 Ibid.29 Dehm and Müller-Peters (2001), Müller-Peters (1998).30 Simon (1957), Burgoyne, et al. (1999).31 Fisher (1928), Fisher and Modigliani (1978).32 (Shafir et al. 1997).33 Ibid, p 346.10 Discussion Paper No.24  June 14, 2011
  11. 11. Another example includes the undue influence of sunk costs and the 34underweighting of opportunity costs relative to out-of-pocket costs.Another effect that is associated with judgement and decision-making is the "Anchors" are widelyanchoring effect, which may, like money illusion, appear as a result of the useddifference in nominal values. People tend to compare familiar prices withother prices and then use these comparisons to form their opinions aboutprices or price changes. One can call these reference prices “anchors.”Thus, if the prices of these anchors rise, then the individual will perceivehigher inflation. Such anchors have a systematic influence on subsequentjudgements in that, for example, higher-priced anchors lead to higher priceestimations.35 In general, anchoring effects are defined as “the assimilation 36of a judgement of salient standard of comparison.”With regard to money, several lines of research have documented how priceestimations systematically deviate in the direction of such anchors, and howthe perception of prices systematically depends on the value of theseanchors.In bargaining research, it is well known that the first offer serves as ananchor that systematically affects the height of the first counteroffer.37 Forexample, if people are confronted with a high price for a product and,subsequently, this price is lowered to a more moderate price, they are morewilling to buy the good than if they are confronted with the moderate offer atthe beginning. This can be explained by the fact that the first price serves asa reference price and influences the perception of the subsequent moderateprice via an anchoring effect.38Since people are familiar with nominal values in their former, nationalcurrency, these familiar values might be automatically salient and serve asan anchor if people consider new prices or salaries in euros. As aconsequence, if the former national currency has lower nominal values thanthe new currency (this is the case only for the Irish pound), the lower anchorvalues would decrease price estimations. If, however, the former currencyhas higher nominal values than the euro (the case of most countries in theeuro area) from the anchoring effect, one could expect an opposite result.39Aside from these effects caused by the changes in nominal values, thechange of the money system itself from a national to an international, pan-European currency could have an impact on processes such as theperception of salaries and the estimation of prices. As stated above, peoplecan have different attitudes towards the new currency, and these caninfluence the perception of money in general and processes like theestimation of prices in particular.According to prospect theory, which says that economic situations are People tend to notice ad-viewed in relation to a reference point and that losses are perceived as be- verse developmentsing more significant than equivalent gains, people tend to estimate their per- moresonal losses and gains compared with these anchors. Furthermore, becauselosses seem much bigger than gains relative to the anchor point, it can bethat people perceive more losses than gains when a new currency isintroduced (even when, in absolute terms, the changes are equal). Thissituation can be the cause of economic or symbolic conditions:40 (a) it seems34 See also Thaler (1992).35 Northcraft and Neale ( 1987).36 See Mussweiler and Strack ( 2000), p.1038, Jonas et al. (2001)37 See Kristensen and Gaerling (1997), (2000) .38 Jonas et al (2001).39 Ibid.40 Burgoyne et al (1998).Discussion Paper No. 24  June 14, 2011 11
  12. 12. that most of the benefits are expected to accrue to those in finance andbusiness; and (b) instead of a national currency with all its symbolicreferents, people have to deal with the potentially “faceless” euro. So, it isprobable that, when prices are converted from an old currency, any form of“rounding up” of prices in favour of the seller is likely to be felt more keenlyas a loss, than any equivalent gain from “rounding down” in favour of thebuyer.But even if prices were calculated correctly, customers tend to perceive them Perception of priceas higher. The main reasons behind this are simply mistakes in calculations. changes is closely re-For example, in Germany the exchange rate was EUR 1 equals DM 1.9533, lated to the attitude to-but people tended to calculate using a ratio of 1:2. As a consequence, they wards single currencyoverestimated prices substantially. In the relevant literature, this is called a“selective error correction,” which means that people do not correct their cal-culations when the results confirm their beliefs.Expectations, concerns, and beliefs. As was stated above, the attitude Currency has two mean-towards a new currency can influence the perception of prices and wages. ings – symbolic and eco-As discussed, people’s views in the UK on the single currency are influenced nomicby the strength and character of their attachment to their national identity.Just as money can be seen to have two “sides” - economic and symbolic - itmay also be a part of national pride. The latter refers to cultural/sentimentalattachment to symbols of nationhood such as the royal family in the UK, aswell as a more instrumental attachment based upon the perceived benefitsof citizenship.41 The strongest direct influence on anti-euro sentiment is thecultural dimension of attachment, with the effects of instrumental attachmentbeing moderated by the perceived benefits of adopting the euro.42As was stated above, the attitude towards the euro is affected by howpeople felt about their own currency – the deutsche mark was much moreappreciated then the euro. Even US dollars seemed, from the point of viewof euro area consumers, more attractive than the euro.If such a sentimental attachment to the national currency exists, it is hard to The national currency inmake people accept the euro. This is to a large extent the case in Estonia as Estonia was a symbol ofwell. Estonians saw themselves as belonging to an independent nation when national independencythey introduced the kroon. After the collapse of the Soviet Union, the three and sovereigntyBaltic countries introduced their own national currencies – this made peopleunderstand that these countries were independent and sovereign states. Forthat reason, we believe, that, in the case of Estonia, the attitudes towardsthe euro are substantially influenced by national identity, which is determinedthrough the national currency.43Propaganda, communication, and attitude change. The literature dealing Educating people usingwith propaganda, communication, and changing attitudes is a “two-edged mass media might actsword”: some of the literature argues about tactics of mass communication like a "two-edged sword"and persuasion and the susceptibilities of populations to persuasion, whileanother branch of the literature deals with protecting the consumer. On theone hand, one may wish to ensure that citizens participating in a democraticprocess are as fully informed as possible, and that people have equalopportunities to learn about the new currency. On the other hand, onedoesn’t want to make consumers victims of hype and half-truths propagatedby politicians.People’s demand for information can be addressed by applying suggestionsfrom research on communication models.44 The “communication41 Cinnirella (1996).42 Routh and Burgoyne (1998).43 It is quite common for elderly people to think that Estonia has departed from one union to join another, and the meaning of the union is not so positive.44 Burgoyne et al. (1999).12 Discussion Paper No.24  June 14, 2011
  13. 13. 45 46organization” approach and “innovation-diffusion theory” say thatcommunications are most effective when both the mass media andinterpersonal channels are used. The mass media will be most useful inproviding information and generating knowledge about the euro. Thisfoundation can be built upon using existing social networks andinterpersonal contacts. A greater impact on attitudes will come from smallgroup discussions about the impact of the euro on the local community,conducted by opinion leaders and esteemed figures in the community.475. Inflation perception, expectations, and actual inflationin euro area countries after euro adoption Perceived inflation isPerceived inflation can be defined as consumers’ own rate of inflation, pro- measured using mainlyduced, for instance, by the media or personal experience. According to this survey resultsdefinition, it can hardly be objectively measured. Most of the research usesthe Consumer Confidence Barometer survey, conducted by the EuropeanCommission; this survey, which is carried out every year, includes all EUmember states and thus gives us the opportunity to compare different coun-tries’ inflation perceptions. Usually the measure of perceived inflation isgiven as the percentage change between respondents who say that priceshave risen and those who believe that prices have fallen. Another way tocalculate perceived inflation is to estimate it from survey results, but thisprocess is subject to restrictive assumptions.The exact wording of the question in the consumer survey is “How do youthink that consumer prices have developed over the last 12 months?” Possi-ble responses are as follows: (a) “risen a lot”; (b) “risen moderately”; (c)“risen slightly”; (d) “stayed about the same”; (e) “fallen”; and (f) “don’t know.”The percentage balance between the different answers is calculated in thefollowing way:Balance = percentage (a) + 0.5 x percentage (b) –0.5 x percentage (d) –percentage (e)Given the equation above, the value of 20, for example, would mean that theshare of those who think prices have risen is 20 percentage points higherthan the share of those who think the opposite. The problem here is that ameasure like this is not directly comparable with actual inflation.In addition, the perceived inflation found in surveys can be calculated as theperceived inflation rate. According to Berk (1999) and Forsells and Kenny(2002), the perceived inflation rate is calculated as follows. The inflation rateperceived by people is, by assumption, normally distributed with a certainmean and a certain variance. It follows that the shares of different survey re-sponses can be interpreted as probabilities. The proportions of certain re-sponses (e.g., “fallen”) thus can be interpreted as the probability that theperceived inflation is between certain upper and lower thresholds. Addition-ally assuming that these thresholds are symmetrically located around zero,one can, by means of probabilities derived, derive a relation between themean and the variance of the distribution in request. In order to calculate themean of the distribution, one then has to assume that the mean of perceivedinflation equals the mean of the statistically measured inflation rate. Themean of the distribution estimated in this way is interpreted as the inflation45 See Rothman (1974).46 See Rogers (1983).47 Burgoyne et al (1999).Discussion Paper No. 24  June 14, 2011 13
  14. 14. rate perceived by the general public. All in all, this estimation procedure de-pends on several assumptions, the plausibility of which may certainly bequestioned. We observe prices ofThe pioneering works of Kahneman and Tversky (1979) shows that the per- goods and services thatception of the economic situations depends on the way in which it is pre- we buy, not others - iso-sented, or on its framing. The consumer is confronted with inflation when she lation effectbuys something. And she will perceive inflation more powerfully when thegoods she buys have become significantly more expensive. But, on theother hand, she will barely notice price changes of goods she rarely buys. Another way to measureAnother way to measure perceived inflation is by an index.48 There are dif- inflation perception is toferent effects (loss aversion and isolation effect49) that need to be taken into calculate consumer priceaccount, and for this purpose Brachinger converted the prices to account for index that takes into ac-this loss aversion and weighted them according to the frequencies with count the frequency ofwhich the consumer buys each of the goods concerned. purchasesThis index actually differs from the consumer price index, since this one in-cludes primarily everyday goods that are purchased frequently (in CPI, thefrequencies of purchases are not taken into account).In this paper, we use the methodology employed in Cornille and Stragier(2007) and Aucremann et al (2007) to convert the qualitative data of per-ceived inflation into a quantitative indicator. This indicator will be accordedthe same average value and the same scale as the harmonised index ofconsumer price (HICP) inflation: itP  B it Bi  S i   i , S Biwhere  itP is perceived inflation quantified for country i in period t.  i andS i are, respectively, the average and the standard deviation of HICP infla-tion, while Bi and SBi are the corresponding statistics for the balance ofopinions for country i. The averages and standard deviations are calculatedover a reference period for which there is considered to be a stable relation-ship between measured and perceived inflation. In this paper, the period dif-fers for the selected countries. In old member states (OMS),50 the periodfrom 1995 until 2001 is used (they adopted the euro on January 1, 2002); forSlovenia, the period lasts until the end of 2006; for Malta and Cyprus, untilthe end of 2007; and, for the Slovak Republic, until the end of 2008. Last butnot least, for Estonia the period lasted until the end of the 2010.51 For thesake of having a control group, we set up the group of countries that haven’tadopt the euro – the United Kingdom, Sweden, Latvia, Lithuania, the CzechRepublic, Hungary, Romania, Bulgaria, and Denmark.48 Developed by Hans Wolfgang Brachinger (see for instance Brachinger (2005),(2006))49 Loss aversion – consumers respond more sensitively to the price increases than to reductions;isolation effect – purchases are considered in isolation ,or, in other words, price increases are not offset against price decreases.50 Austria, Belgium, Germany, France, Italy, Ireland, Spain, Portugal, Finland, the Netherlands, Greece, and Luxembourg .51 Those countries are counted in this paper as New Member States (NMS), except Estonia. In the case of Malta and Cyprus, the available data start in2002and 2001, respectively. Therefore, one may consider leaving these two out of the analysis.14 Discussion Paper No.24  June 14, 2011
  15. 15. Euro area actual and perceived inflation rate (in percent)5% HICP, yoy perceived inflation, yoy4%3%2%1%0%-1% Source: Eurostat, ECFIN, authors calculations 1996 1998 2000 2002 2004 2006 2008 2010We are aware that all these countries differ in terms of the structure of theeconomy and the level of development, but in respect to the problem of in-terest, similar factors may influence the perception of price changes in theeuro area as well as in non-member countries. As we are dealing with ratherdifferent countries, we divided them into three groups: (a) the Baltic states(BS = Latvia, Lithuania and Estonia; (b) the central-eastern European coun-tries (CEEC = Hungary, Poland, the Czech Republic, Poland, Bulgaria, andRomania); and (c) the non-euro area developed countries (NEAC = the UK,Sweden, and Denmark).Data used in this analysis are provided by ECFIN and Eurostat. In the case We use data provided byof the OMS, the data series of perceived inflation usually started in 1995, ex- Eurostat and ECFINcept for Finland and Austria (data for both are available since 1996) and forLuxembourg. The latter is quite exceptional – the survey data are availableonly since 2002, and, therefore, Luxembourg is left out of this analysis. TheHICP is available only from 1996 onwards. In terms of testing the above-mentioned assumption that the relationship of perceived and actual inflationis stationary around the constant, we use the unit root test. For the OMS, thedata for all but Finland suggest that the relationship between actual and per-ceived inflation is stationary, i.e., in terms of the usual economic environ-ment, people perceive inflation in a rational way. In the BS group, data onthe Lithuanians’ perceived inflation are available only since May 2001; in theCEEC group, the same holds for Bulgaria, Romania, and Poland; and, in theNEAC group, survey data on Sweden are available since October 1995. Al-most all countries have actual inflation (HICP) data available from 1996 on-wards, except for Bulgaria (available from December 1996 onwards).Perceived inflation is calculated for all these countries (see the graphs in People perceived infla-Appendix 2), and, to test whether the relationship between these inflation tion quite objectively be-rates is stationary, we calculated the difference between the perceived and fore the euro adoption inactual inflation rate and used the unit root test to test for stationarity before selected countriesthe adoption of the euro (in the case of euro area countries); after that, welooked at the same difference for the whole sample. This allows us to com-pare both tests and to check whether the relationship between these twochanges significantly. Results of the tests are presented in Table 1 in Ap-pendix. Under the null hypothesis, the difference is nonstationary, i.e., it isassumed to have a unit root. We reject the null hypothesis at the level of10% (the p-value should be less than 0.1) for most of the countries (exceptfor Finland, Ireland, and the Netherlands) for the pre-euro period; in thisDiscussion Paper No. 24  June 14, 2011 15
  16. 16. case, the difference between quantified perceived and actual inflation is sta-tionary. This means that there has been a nonstationary relationship be-tween actual and quantified perceived inflation in Finland, Ireland, and theNetherlands in the past, which, in turn, indicates that the instability problemfor the more recent period is irrelevant. For all other euro area countries, thenull hypothesis is rejected, which means than one can agree that there wasa stationary relationship between perceived and actual inflation. This, in turn,means that people’s perception of the price changes was relatively good be-fore the euro cash changeover, and that the deviation from this stable rela-tionship was quite fugacious.For the whole period, the null hypothesis cannot be rejected in the case of The effect of the cashAustria, France, Greece, and the Netherlands. Since the latter country had a changeover on peoplesnonstationary relationship before euro adoption as well, we do not discuss it perceptions will vanishany further. This is a bit different result from Jemec’s (2010), who found that graduallymost of the euro area countries had nonstationary relationships betweenperceived and actual inflation for the whole period (until August 2009). Ourevidence shows that the effect of the euro cash changeover will vanish, andthat the stationary relationship between perceived and actual inflation willremain in place. Even though the relationship will remain stationary in thelong run, the gap between perceived and actual inflation did widen shortlyafter the euro cash changeover (see graphs in the Appendix), and the teststaken do not say anything about causality (i.e., whether or not perceived in-flation causes actual inflation. as suggested by the theory). Therefore,Granger causality tests were taken.For comparison, tests were made for non-euro area countries as well; before In non-euro area coun-the first wave of euro cash changeovers (in 2002), we can reject the null hy- tries the stationary rela-pothesis for most countries (for Lithuania, Poland, Romania, and Bulgaria, tionship between per-the time series were too short), except for the UK. For the whole period, the ceived and actual infla-stationary relationship remains (except for Poland). tion remainsThe other question that arises in the literature is whether changes in per- Granger causality testsceived inflation may cause changes in expected and, through that – actual will show how much in-inflation. To answer this question, we have constructed Granger causality formation one variabletests (see results in Appendix, Table 2), which are usually applied to test cer- has to predict the othertain relationships between variables. In this paper, the variables are per-ceived, expected, and actual inflation in selected countries. The test resultsmay not indicate a strong one-way relationship or the direction of the influ-ence – but the results will show how much information is in one variable topredict the other. The null hypothesis is that variable A does not Grangercause variable B, which means that, if we can reject the null hypothesis,there is a relationship between variables. The tests, the results of which arepresented in the Appendix, are run using stationary variables (monthlygrowth rates), and all tests are made with lags of 2, 6, and 12 months. In Ta-ble 2, we present only statistically significant relationships (at the 10% level,i.e., the p value is less than 0.1).Test results show in many cases a rather strong relationship between these Test result differ amongvariables. Monthly changes in actual inflation cause changes in expectations countriesin Germany and changes in perceptions in Austria, Italy, and Slovenia. Itwould not be surprising to find this relationship to be more widespread as,according to the questionnaire, the inflation perception indicator should beexplained by consumer price inflation, and expected inflation should also berelated to actual inflation – if we assume stable inflation. Changes in expec-tations influence actual inflation in Austria, Estonia, Slovenia, and the UK.This result is also quite expected – in many economic theories, the actualinflation rate is determined by expectations. It is rather interesting thatchanges in expectations have effects on monthly changes in inflation per-16 Discussion Paper No.24  June 14, 2011
  17. 17. ceptions in so many countries. The relationship between monthly changes inexpectations and monthly changes in inflation perceptions is not so clear,but they are closely related. This is partly explained by the experimentalpsychology literature,52 and, as pointed in Jemec (2010), the influence of in-flation perceptions on inflation expectations is explained by the rigidity of thehuman mind, i.e., if one thinks that prices have been rising, one most proba-bly expects them to rise further. These two indicators are closely related,and, at different times, the two data series may explain each other in manycountries.A monthly change in perceived inflation affects monthly changes in actualinflation, according to the tests in Ireland, the Netherlands, Sweden, andSlovenia. In the case of Slovenia, the relationship goes both ways – changesin actual inflation cause changes in inflation perceptions and vice versa.6. What will it be for Estonia? Short discussion of theEstonian case The same factors affectEstonia is now facing the question of whether the changeover will bring Estonians’ perceptionsabout a considerable price increase. One may assume that, as in the euro as in other euro areaarea, some of the regular price changes might be timed for the changeover countriesperiod because of the menu costs in Estonia, as well as the other euro areacountries. However, many entrepreneurs have agreed not to increase prices(the Agreement of Honest Pricing, or Ausa Hinnastamise Lepe), and therehas been no evidence yet that they have not kept their part of the deal. Atthe same time, expense arguments might have a more significant impact onthe prices of certain goods and services (price increases are allowed if theyare economically justified), and therefore the price rise might be associatedwith the new currency in circulation. The actual price changes are, as de-scribed in economic theory, influenced by competition on the market – thetighter the competition, the less likely prices will increase due to the changeof currency in circulation. Knowing that Estonia is a well-functioning marketeconomy,53 the euro adoption should not have a significant inflationary im-pact on price levels in Estonia (according to the recent study by Eurostat, theeffect of euro cash changeover on Estonian price level is 0.2-0.3 percentagepoints54). Most of the Estonian retail sector is concentrated in large chains,which means that pressure for price increases stemming from cash change-over should be smaller in Estonia than in countries where small shops con-stitute the majority of the retail sector. But, as the experience of other euroarea countries has shown, prices of certain services may indeed increase(e.g., restaurants and cafes, bus tickets, etc.) due to rounding and/or post-poned price increases. The latter might be especially the case for restau-rants and cafes. We know that pricesOn the basis of the experience of countries that have already adopted the change due to differenteuro, it cannot be ruled out that the Estonian population might perceive the reasons, but peoplerise in prices to be higher than the actual price growth; this may be caused might associate it withby different factors (like the food price increase that will be associated with euro adoptionthe new currency, e.g.). Before the EU accession, consumers’ fears of infla-tion grew, due to the heavy media attention as well as the expected changes(see graph in the Appendix). After Estonia joined the EU, the number ofthose consumers who felt that prices were increasing faster, grew. Percep-tions after the euro cash changeover will most probably rise, as seen in the52 See, for instance ,Traut-Mattausch et al (2004), among others.53 Lättemäe (2005).54 Compliance Monitoring Information Note for EstoniaDiscussion Paper No. 24  June 14, 2011 17
  18. 18. experience of other euro area countries. It might happen that increases inprices in certain fields (e.g., electricity and public transport) will be moremarked than the more modest price increases (or even declines) of somegoods in the basket of goods and services, as people have different con-sumer baskets; moreover, as mentioned above – people observe the pricesof those goods that they purchase more often and do not take into accountthe price falls of those goods they seldom if ever buy, but which are takeninto account in the overall consumer price index.In sum, prices will change in Estonia, as well as worldwide, for different rea-sons, but the change in prices due to the change of currency in circulationshould not be large. Prices have been rising, and it might very well be thecase that people in Estonia will correlate the current price rise with the newcurrency. As is said in the relevant literature – it is not wrong how peopleperceive inflation, since every household has a different consumer basket,which hardly coincides with the average consumer basket calculated by theStatistical Office. Additionally, people observe prices in isolation and re-member only the prices of a few products/services; if those prices havechanged, they amend their perceptions accordingly. And as mentionedabove, if people make mistakes in calculating prices into kroons, they tendnot to correct them if these miscalculations coincide with their beliefs aboutthe new currency. Luckily, more and more people favour a common currency– in January 2010 it was a bit more than half of the respondents of a survey,and, a year later, in January 2011 already more than 60% of the respon-dents favoured the euro.7. ConclusionThe discussion about inflation perception and euro adoption has been quiteintense in recent years, with most of the papers dealing with the first wave ofcurrency changeover (in 2002). We discuss currency changeover a bit morebroadly, considering the reasons behind price increases in times of noshocks and in times of shocks such as a change of currency in circulation.Discussing the relationship between actual and perceived inflation, oneneeds to explain why people may change their opinions about price in-creases after the country has adopted a new currency. The psychologicalfactors behind adopting a new currency and inflation perceptions have alsodescribed in this paper.The first part of the paper is devoted to the topic of price changes, i.e., whyprices change during so-called stable economic development. We thenturned to the reasons why prices change after a shock like a currencychangeover. From the literature, we found that prices tend to be rathersticky, and on average prices change once a year (this frequency differsamong different groups of goods and services). According to a survey con-ducted in Bank of Estonia, the price-setting behaviour of Estonian firms doesnot differ much from their euro zone counterparts (except that competition issaid to be perceived as stronger than in the euro area).But what about the factors that, in addition to regular factors, influence pricechanges in times of currency changeover? As is known in the case of perfectcompetition and with rational consumers, the change in the tool of exchangeshould not transfer into prices. In reality, however, people are not rational(bounded rationality), and their decisions are based completely on emotions,the information available to them, and other factors. They are affected bymoney illusion – observing only the nominal value of the currency, theytherefore may overlook their consumption habits. Firms are, however, facingdifferent costs during the currency changeover, like the need to change price18 Discussion Paper No.24  June 14, 2011
  19. 19. tags (menu costs), IT costs, the need for larger amounts of cash during theperiod of parallel circulation, etc. The transfer of these costs into prices de-pends on firms’ pricing strategies and their beliefs about the nature and per-sistence of the costs (enterprises have identified the increased costs as themain reason behind the price rise). Besides, the price changes may also beaffected by marketing strategies. Specifically, firms may round prices up-wards using psychological pricing as one marketing tool.After discussing price changes from the firm’s side, we discussed the psy-chological factors behind consumers’ inflation perception, especially aftercurrency changeover. The way people learn, memorize, or identify them-selves – all this has an impact on the perception of price changes. The toolof consumer psychology is useful in understanding this phenomenon.In the empirical analysis, we analysed the euro area countries together withother EU countries, in order to add non-euro area countries as a controlgroup. Our findings show that there is a stationary relationship between ac-tual and perceived inflation in most of the countries before 2002 (before thefirst wave of the euro cash changeover), which indicates that people tend toperceive price changes in a stable environment quite rationally. After theeuro cash changeover, as was found in other similar papers, the picturechanges somewhat – perceived inflation was much higher than actual infla-tion. The gap between these two persisted until 2008, when both started tomove similarly again. Our test results for the whole period show that in mostof the countries the stationary relationship between actual and perceived in-flation remained. Many papers that use shorter time series show much morepersistent results of breaking the stationary relationship between actual andperceived inflation after the currency changeover. One may say that, shortlyafter the changeover, the gap between perceived and actual inflation didwiden for some years and, after that, actual inflation began to catch up withthe perceptions; this might indicate that people’s beliefs about price changesself-fulfilled after some years.Tests on the relationship between actual and perceived inflation do not,however, show the magnitude or direction of the influence that people’s per-ceptions may have on actual and/or expected inflation. Granger causalitytests show a rather strong interrelationship between expectations and per-ceptions, which one may explain by the rigidity of the human mind. Effects ofchanges in perceived inflation on actual inflation were evident in only a fewcountries (Ireland, the Netherlands, Sweden, and Slovenia). At the sametime, perceptions have an indirect effect on changes in actual inflation in Es-tonia – changes in perceived inflation influence changes in expectations,which, in turn, affect changes in actual inflation.Many opinion polls suggest that people’s strongest fears in relation to euroadoption have been of faster inflation accompanying the euro cash change-over (which, in turn, has gained a lot of media attention – the price increaseshave been discussed more thoroughly than price decreases, if the latterhave been discussed at all). The reasons behind this fear are mostly psycho-logical, but this does not decrease the need for their serious considerationand for the dissemination of unbiased and relevant information on inflationissues. Relying on the euro area experience, the euro cash changeover maynot necessarily bring about a crucial price increase or acceleration of infla-tion, but the changes may be more pronounced in the prices of everydaygoods, and, therefore, perceived inflation may increase.Discussion Paper No. 24  June 14, 2011 19
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  23. 23. Appendix 1Table 1. Unit root tests at the country level whole period (until before euro adoption 12.2010) lag lag length=0 length=0 (based on (based on SIC max SIC max P-value lag) P-value lag) Euro area countriesAustria 0.0461 10 0.2163 13Belgium 0.0373 10 0.0435 13Cyprus 0.0049 11 0.0012 12Germany 0.0005 10 0.0626 13Ireland 0.1573 10 0.0965 12Spain 0.0313 10 0.0417 13Finland 0.1994 10 0.0969 13France 0.0499 10 0.1434 13Greece 0.0471 10 0.3982 13Italy 0.0090 10 0.0002 13Malta 0.0035 10 0.0313 11Netherlands 0.4485 10 0.1721 13Portugal 0.0717 10 0.0214 13Slovak Republic 0.0015 12 0.0008 13Slovenia 0.0004 12 0.0078 13 Non-euro area countriesBulgaria (series too short) 0.0613 12Denmark 0.0135 10 0.0002 13Czech Republic 0.0761 10 0.0281 13Hungary 0.2054 10 0.0430 13Estonia 0.0799 10 0.0089 13Latvia 0.0003 10 0.0006 12Lithuania (the series too short) 0.0246 12Poland (the series too short) 0.2424 12Romania (the series too short) 0.0062 12Sweden 0.0402 10 0.0000 13United Kingdom 0.1112 10 0.0015 13Discussion Paper No. 24  June 14, 2011 23
  24. 24. Table 2. Results of the Granger causality testsInflation does not Granger cause inflation expectations Germany 2 177 2.61959 0.0757 6 173 2.17734 0.0478 12 167 1.98448 0.0297Inflation expectation does not Granger cause inflation Austria 12 167 2.00859 0.0275 Estonia 2 177 2.34431 0.099 Slovenia 2 175 2.94943 0.0551 UK 12 166 1.62345 0.0914Inflation does not Granger cause inflation perceptions Austria 6 173 2.01669 0.0664 12 167 2.01113 0.0272 Italy 2 174 5.04299 0.0075 6 166 3.32389 0.0042 12 154 1.72892 0.0677 Slovenia 2 175 5.11897 0.0069 6 171 2.02757 0.065 12 165 1.98604 0.0297Inflation perceptions does not Granges cause inflation Ireland 6 141 1.90585 0.0847 Netherland 12 167 3.2509 0.0004 Sweden 2 177 2.4279 0.0912 Slovenia 6 171 1.94429 0.0769 12 165 1.74454 0.0635Inflation perceptions does not Granger cause inflationexpectations Bulgaria 2 114 3.94305 0.0222 6 110 1.45798 0.2008 12 104 1.92248 0.0438 Estonia 6 186 9.8456 0.0000 12 180 18.1456 0.0000 Spain 2 186 2.73797 0.0674 12 166 3.35656 0.0003 Germany 6 186 3.69026 0.0018 12 180 1.97934 0.0295 Hungary 2 190 5.01064 0.0076 Ireland 2 157 1.2427 0.2915 6 153 2.25599 0.0414 12 147 1.60591 0.0984 Italy 6 179 5.10059 8.00E-05 12 167 2.33224 0.0093 Malta 2 96 3.39563 0.0378 6 92 2.39397 0.0354 12 86 3.25383 0.0012 Slovenia 2 176 3.04115 0.0504 Slovakia 2 136 7.73718 0.0007 6 128 5.16581 0.0001 12 116 3.79967 0.000124 Discussion Paper No.24  June 14, 2011
  25. 25. Inflation expectations does not Granger cause inflationperceptions Austria 12 171 10.7953 4.00E-15 Bulgaria 2 114 8.2447 0.0005 6 110 3.06972 0.0086 12 104 2.94582 0.002 Cyprus 2 114 0.87186 0.4211 6 110 1.84131 0.099 12 104 1.69719 0.0832 Germany 2 190 22.1096 0.000 6 186 7.38986 0.000 12 180 7.39239 0.000 Estonia 2 190 3.22693 0.0419 12 180 2.16493 0.0159 Spain 6 178 52.763 6.00E-36 12 166 34.4967 5.00E-36 Hungary 2 190 18.1233 6.00E-08 6 186 7.95344 1.00E-07 12 180 4.58848 2.00E-06 Latvia 2 190 22.8129 1.00E-09 6 186 8.20342 8.00E-08 12 180 4.27521 8.00E-06 Malta 6 92 2.45396 0.0315 12 86 4.142 0.0001 Netherlands 2 190 15.6545 5.00E-07 6 186 8.50835 4.00E-08 12 180 5.99334 2.00E-08 Romania 2 114 3.28876 0.041 6 110 3.88585 0.0016 12 104 3.05261 0.0014 Slovenia 2 176 2.26827 0.1066 6 172 1.91623 0.0813 12 166 3.0101 0.0009Discussion Paper No. 24  June 14, 2011 25

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