Preferences over Inflation and Unemployment: Evidence from Surveys of Happiness

Modern macroeconomics textbooks rest upon the assumption of a social welfare function defined on inflation, p, and unemployment, U. However, no formal evidence for the existence of such a function has been presented in the literature. Although an optimal policy rule cannot be chosen unless the parameters of the presumed W(p, U) function are known, that has not prevented its use in a large theoretical literature in macroeconomics. This paper has two aims. The first is to show that citizens care about these two variables. We present evidence that inflation and unemployment belong in a well-being function. The second is to calculate the costs of inflation in terms of unemployment. We measure the relative size of the weights attached to these variables in social well-being. Policy implications emerge. Economists have often puzzled over the costs of inflation. Survey evidence presented in Robert J. Shiller (1997) shows that, when asked how they feel about inflation, individuals report a number of unconventional costs, like exploitation, national prestige, and loss of morale. Skeptics wonder. One textbook concludes: “we shall see that standard characterizations of the policy maker’s objective function put more weight on the costs of inflation than is suggested by our understanding of the effects of inflation; in doing so, they probably reflect political realities and the heavy political costs of high inflation” (Blanchard and Fischer, 1989 pp. 567–68). Since reducing inflation is often costly, in terms of extra unemployment, some observers have argued that the industrial democracies’ concern with nominal price stability is excessive—and have urged different monetary policies. This paper proposes a new approach. It examines how survey respondents’ reports of their well-being vary as levels of unemployment and inflation vary. Because the survey responses are available across time and countries, we are able to quantify how self-reported well-being alters with unemployment and inflation rates. Only a few economists have looked at patterns in subjective happiness and life satisfaction. Richard Easterlin (1974) helped to begin the literature. Later contributions include David Morawetz et al. (1977), Robert H. Frank (1985), Ronald Inglehart (1990), Yew-Kwang Ng (1996), Andrew J. Oswald (1997), and Liliana Winkelmann and Rainer Winkelmann (1998). More recently Ng (1997) discusses the measurability of happiness, and Daniel Kahneman et al. (1997) provide an axiomatic defense of experienced utility, and propose applications to economics. Our paper also borders on work in the psychology literature; see, for example, Edward Diener (1984), William Pavot et al. (1991), and David Myers (1993). Section I describes the main data source and the estimation strategy. This relies on a regressionadjusted measure of well-being in a particular year and country—the level not explained by individual personal characteristics. This residual macroeconomic well-being measure is the paper’s focus. * Di Tella: Harvard Business School, Morgan Hall, Soldiers Field, Boston, MA 02163; MacCulloch: STICERD, London School of Economics, London WC2A 2AE, England; Oswald: Department of Economics, University of Warwick, Coventry CV4 7AL, England. For helpful discussions, we thank George Akerlof, Danny Blanchflower, Andrew Clark, Ben Friedman, Duncan Gallie, Sebastian Galiani, Ed Glaeser, Berndt Hayo, Daniel Kahneman, Guillermo Mondino, Steve Nickell, Julio Rotemberg, Hyun Shin, John Whalley, three referees, and seminar participants at Oxford University, Harvard Business School, and the NBER Behavioral Macro Conference in 1998. The third author is grateful to the Leverhulme Trust and the Economic and Social Research Council for research support. 1 See, for example, Olivier Blanchard and Stanley Fischer (1989), Michael Burda and Charles Wyplosz (1993), and Robert E. Hall and John Taylor (1997). Early influential papers include Robert J. Barro and David Gordon (1983). 2 N. Gregory Mankiw (1997) describes the question “How costly is inflation?” as one of the four major unsolved problems of macroeconomics. 3 A recent contribution to this debate in the United States is Paul Krugman’s piece, “Stable Prices and Fast Growth: Just Say No,” The Economist, August 31, 1996.