Inflation, Unemployment and Happiness

When exploring further the relationship between inflation, unemployment, and growth, I found something that caught my eye: the relationship between inflation, unemployment, and happiness. This interested me because GDP is used to measure "wellbeing" as a basic proxy when many would argue that what really matters is happiness. Thus, it might make more sense to measure the correlates of happiness. In Di Tella et. al.'s 2000 paper, "Preferences over Inflation and Unemployment: Evidence from Surveys of Happiness" they find that from an OLS regression of reported life satisfaction in Europe from 1975 to 1991, happiness and unemployment and inflation are both correlated with lower levels of life-satisfaction. Even when controlling for the personal characteristics of the respondents, country fixed-effects, year effects, country-specific time trends, and a lagged dependent variable, both inflation and unemployment were significant.  A percentage point increase in unemployment is associated with a -2.8 through -2.0 change in reported life satisfaction. A percentage increase in inflation is also associated with decreases in happiness, specifically a one percentage point increase leads to a between -1.4 and -1.2 decrease in life satisfaction. Life satisfaction is on a scale of 1-4, so these changes are huge. The study suggests that Europeans would trade off a 1 percentage point increase in the unemployment rate for a 1.7 percentage-point increase in the inflation rate.

This points to a discrepancy between the economic and psychological effects of inflation. While life satisfaction may drop significantly during periods of higher inflation, economic growth is less effected. From Barro and Easterly's 1995 Working Paper, they found that when crisis of high-inflation (over 40 percent) are excluded, inflation is not significantly correlated with changes in economic growth.

Thus, one of the main problems with inflation may be psychological. Older people may be nostalgic for nickel and dime stores and 25 cent gallons of gas, regardless of what their incomes were actually.