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Perceived Inflation under Loss Aversion

  • Lena Dräger

    ()

    (University of Hamburg)

  • Jan-Oliver Menz

    ()

    (University of Hamburg)

  • Ulrich Fritsche

    ()

    (University of Hamburg and KOF, ETH Zurich)

Building on Prospect Theory, we apply the concept of loss aversion to the formation of inflation perceptions and test empirically for non- linearities in the inflation-perceptions relation for a panel of 10 Euro area countries. Specifically, under the assumption of loss aversion, inflation changes above a certain reference rate will be perceived more strongly. Rejecting rationality of inflation perceptions in general under symmetric loss and in a majority of cases under flexible loss functions, panel smooth transition models give evidence of non-linearities in the inflation perception formation regarding both actual inflation and time. This result is confirmed by dynamic fixed effects estimates, where the slope of the estimated value function is significantly steeper in the loss region and the implied average reference inflation rate is found close to 2%.

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File URL: http://www.wiso.uni-hamburg.de/repec/hepdoc/macppr_5_2011.pdf
File Function: First version, 2011
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Paper provided by Hamburg University, Department Wirtschaft und Politik in its series Macroeconomics and Finance Series with number 201105.

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Length: 42 pages
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Handle: RePEc:hep:macppr:201105
Contact details of provider: Web page: http://www.wiso.uni-hamburg.de/dwp
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