Poor Households and the Weight of Inflation

Public opinion and the perceptions of poorer households consistently indicate that the poor are most exposed to inflation. Meanwhile, the empirical literature on income-dependent inflation inequality remains ambiguous. In this paper, we explore two different explanations for this inflation-inequality puzzle. First, we examine the role of sectorial heterogeneity in modulating the impact of cost-push shocks on households. An Input-Output analysis for 21 EU countries within the global production network shows the income-dependent impact of a price shock to be highly contingent on the sector of origin. While these findings suggest a partial explanation for the ambiguous results on inflation inequality, they do not point to a consistent overexposure of lower-income households. As a second explanation, we propose the income-weighting of price shock effects as opposed to the conventional expenditure-weighting. This approach considers the share of income allocated to consumption and thus directly affected by a change in prices. Using a utility framework, we demonstrate that under bounded rationality the decline in utility is indeed proportional to the average propensity to consume times the change in prices. Introducing these income-weights in our empirical analysis, we find lower-income households to be disproportionally affected by every sectorial price shock, fully explaining the inflation-inequality puzzle.