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Discussion Paper                                                              No. 24  June 14, 2011




Perceived inflation after euro cash changeover:
the case of Estonia
The adoption of euro has been accompanied by a larger increase in inflation perceptions than
actual inflation developments. The wedge between those two has widened right after the
adoption of euro in all euro area countries. On one hand, the explanation of the gap between
actual and perceived inflation is related to the measuring of those rates – the indices reflect
price changes differently. On the other hand, there is a bulk of ideas and theories related to
the consumers’ ability to adapt new value of exchange: the attitude towards new currency, the
role 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 a
shock like change in value of exchange occurs. In the literature prices tend to be rather sticky
during the stable economic development – the changes in prices occur only once a year on
average. The currency changeover might influence the price level via costs – firms are facing
different costs during the currency changeover, like the need to change price tags, related IT
costs, 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 strategies
as well as on the overall competition level in the sector. In addition, price changes may stem
from the marketing strategies (for instance, psychological pricing).

Even though the prices may be calculated correctly people tend to perceive higher prices
compared to those in the national currency. In this paper we analyse different psychological
factors that influence the perception of prices, like the way people learn, memorise or identify
themselves or how they feel about the new currency. People tend, for example, calculate
prices in euros back into national currency although the new currency has been in circulation
for some time. The comparison with prices in national currency that was valid more than six
months ago may be one of the causes behind the wedge between the actual and perceived
inflation.

In the empirical analysis we use data on euro area and EU countries and add some non-euro
area 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 people
tend 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. We
conclude that the gap between perceived and actual inflation persisted for some years and
within time disappeared again. We also analyse the causality between actual and perceived
inflation rate using Granger causality test. The tests however will not show the magnitude or
direction 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 show
that the changes in perceived inflation may explain the changes in actual inflation in only few
countries (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.
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 Paabut
Acting Chief Economist at Swedbank Estonia




Contents:                                                                            Page:
1.    Introduction                                                                        3
2.    Price changes before and after euro cash changeover: price do change...             4
3.    The presence of a shock: how does euro cash changeover affect prices?               6
4.    Inflation perception - psychological factors behind it                              8
5.    Inflation perception, expectations, and actual inflation in euro area countries after
euro adoption                                                                             13
6.    What will it be for Estonia? Short discussion of the Estonian case                 17
7.    Conclusion                                                                         18




2                                                                            Discussion Paper No.24  June 14, 2011
1. Introduction
                                                                                                          The way people perceive
In modern economic theory, the role of information has been central in de-
                                                                                                          inflation may have real
scribing factors behind aggregate fluctuations and business cycles. This is
                                                                                                          effects
especially 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 affects
the aggregate level as well. In recent years, the discussion on inflation ex-
pectations and inflation perception has been widespread and has focused on
inflation perceptions after a currency changeover. In many cases, the euro
cash changeover is associated with the so-called nimbus of price increase,
and therefore it is thought that it might undermine the credibility of official
price measures and/or adversely influence public opinion about the new cur-
rency. In addition, perceived inflation may have real effects. For example, if
consumers’ overestimation of inflation results in an underestimation of their
purchasing 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 will
cut back on consumption. In addition, perception may carry over to expecta-
tions. The experience of Austria2 shows that, until the end of 1999, inflation
expectations were slightly lower than perceived inflation; from 2000 to 2002,
both rates were almost identical. However, the picture changed after Austria
adopted the euro in 2002. Perceived inflation was approximately 1.5 per-
centage points higher on average until 2003, after which expected inflation
was revised significantly upwards (both expected and perceived inflations
were brought together).

                                                                                                          Expectations play impor-
In economic theory, inflation expectations have an important role to play. Ac-
                                                                                                          tant role in economic
cording to Phelps’s and Friedman’s work on the augmented Phillips curve,
                                                                                                          theory
expected inflation is one of the most important determinants of actual infla-
tion.3 Friedman (1968) said that the Phillips curve relationship is valid only in
short 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 and
unemployment disappears. More recent studies on Phillips curve (see for in-
stance Clarida et al (1999) and Blanchard and Gali (2007)) are related to the
New Keynesian dynamic stochastic general equilibrium models, where the
prices are assumed to be sticky. Like the expectations augmented Phillips
curve, the New Keynesian framework also states that the relationship be-
tween inflation and unemployment is temporary and increased inflation may
reduce unemployment only in the short run, but not permanently.

Real business cycle theory says that, according to the theory of the natural
rate, 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 in
inflation will affect real variables like output and unemployment.

Many papers have found that the wedge between perceived and actual price
changes has widened in the euro area, especially after the introduction of
euro banknotes and coins; at the same time, the newest papers show that in
nonexceptional circumstances people perceive inflation rationally and their
perceptions and expectations become exaggerated in the case of shock

1 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
(e.g., currency changeover). In sum, one may divide the relevant literature
into three groups. The first group deals with consumers’ perception of prices
of the most frequently purchased goods and services.5 The second group of
papers 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 euro
adoption.

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.)                                                                        80



3%                                                                                                                     60



2%                                                                                                                     40



1%                                                                                                                     20



0%                                                                                                                     0


       Source: ECFIN, Eurostat
-1%                                                                                                                    -20
        95     96     97    98    99     00    01     02    03     04    05       06   07   08     09    10     11


In this paper, we first briefly discuss the reasons why prices change during a
currency changeover. The third chapter deals with inflation perception and
the psychological factors behind it during euro adoption. Then we discuss
price perception, expectations and actual inflation after euro cash change-
over in euro area countries (the analysis covers period from 1997 (or later
depending on the data availability) till 2010). And we conclude with a short
discussion on the Estonian case. As Estonia has adopted the euro only quite
recently (in January 2011), we do not have enough data for a deep analysis
of 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 for
to be more responsive to changes in the costs of intermediate inputs to pro-                                                     different reasons
duction than they are to changes in demand. Or, put differently, changes in
costs seem to be more the reason that prices change than changes in
markups. However, even in so-called customer markets, prices can change
quite 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. At
the 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
According to Cecchetti (1985, 1986), the average time between price
changes 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 high
inflation in the 1970s.8 Carlton (1986) analysed manufacturing firms in the
US and found that the time between price changes varies from 1½ years for
steel and chemicals to ½ year for plywood and nonferrous metals. This
means that pricing behaviour differs among industries. Blinder (1994) and
Blinder 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 per
year, 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 the
prices 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 important
implication of their work is that the frequency of price changes differs
dramatically across goods (their study covers 350 categories of goods and
services, which is about 70 percent of consumer spending and was based
on unpublished data from the Bureau of Labour Statistics for 1995-1997).
For instance, some prices seldom change: prices of newspapers, men’s
haircuts, and taxi fares change in fewer than 5% of the months covered. But,
at the same time, some prices change very frequently, with prices of
gasoline, tomatoes, and air fares changing in more than 70 % of the
months.9

According to Cecchetti (1986), who studied newsstand prices of 38 Ameri-
can magazines over 1953-1979, the time between price changes varied from
1.8 to 14 years. However, Bils and Klenow (2004) find that magazines
(including subscription as well as newsstand prices) exhibit price changes on
average every 11 months. And, more important, magazines prices are at the
stickiest end of the spectrum, i.e., 86% of nonhousing goods prices change
more frequently.10

The other branch of rather sticky prices is the prices of meals in restaurants.
                                11
According to different studies,    restaurant prices are the stickiest. But, in
the case of shocks (such as the euro cash changeover) these prices tend to
increase more than in other sectors, since entrepreneurs will try at least
some 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, Estonian
entrepreneurs change the prices of their main product/service once per
year.12

Recall from university economics lectures – prices do change and the
change is affected by different factors. For instance, if prices of inputs
increase, then there is a high probability that prices of final goods/services
will increase as well. In addition, changes in prices are influenced by
macroeconomic conditions, sectoral conditions (cost structure or degree of
competition), 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
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 had
In the relevant literature, it has been found that the speed of this adjustment                       effect on prices
is to a large extent determined by the beliefs of the entrepreneurs – if
entrepreneurs believe that the change in input prices is temporary, and then
the price of their product will not change. But what about price changes in
case of the shocks like a currency changeover? According to Eurostat
(2003) approximately 50% of goods prices followed the usual path of change
in 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 had
an impact on the prices of approximately 26% of goods groups.13 The price
increase was most apparent in the case of restaurants and cafés, and
hairdressers and beauty parlours, i.e., mainly locally provided services.

Price increases in euro area (EA12) by different goods groups
               alcohol and tobacco
8%
               food
               hairdresser
               HICP
               restaurants and cafes
6%             newspapers, books




4%




2%




0%


     Source: Eurostat

       95     96      97       98   99   00   01   02   03   04   05   06   07   08   09   10   11


There are several reasons why a slight price increase accompanies the cur-
rency changeover; they mostly depend on how well an average company
can manage expenses arising from the changeover.

From economic theory, we know that in the case of perfect competition,                                Price changes depend
where 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 pricing
penses, prices may temporarily increase. After writing off the expenses, the                          strategy
company should return to the previous price level. Other countries’ experi-
ence shows that the related extent of the price increase depends on the
strength of competition in trade. The price increase appeared to be smaller
in smaller shops and in those countries where retail trade concentration was
lower. 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-time
changeover are tied to price developments and replacement of price tags,                              costs related to the
training of employees, accounting in several currencies during the period of                          change in currency
parallel circulation, and, when necessary, purchases of new software.14


13 See also Lättemäe (2005).

14 Lättemäe (2005).




6                                                                                     Discussion Paper No.24  June 14, 2011
In addition to the one-off costs, there are factors that may give rise to one-off
or 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 directly
such as, in the case of currency changeover, the development of new prices,                                                              related to the price
printing of price tags, and remuneration of extra working hours etc. As men-                                                             change process such as
tioned 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 working
riod. Thus, the menu costs directly related to the changeover in fact should                                                             hours etc
decrease costs for the firm, but consumers perceive this as a price change
due to the currency change. Such a pricing strategy is definitely trickier to
implement when the media and public at large take more interest in the price
changes.

Money illusion is a bias in the assessment of the real value of transactions,                                                            People tend to observe
induced by their nominal representations.15 In other words, money illusion                                                               prices in nominal values
describes the phenomenon that people tend to observe nominal values,
since the nominal value of money is salient and a natural unit: the price is
low, when the nominal value of the good is low. Furthermore, money illusion
influences international trade and tourism, or, as Fisher (1928) said: “almost
everyone is subject to the ‘money illusion’ in respect to his own country’s
currency. This seems to him to be stationary while the money of other coun-
tries seems to change”16

There are also other expenses directly related to the euro cash changeover                                                               Firms need to spend on
that 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 to
the prices of goods/services will depend on the strategy firms use – if firm
wants to depreciate the costs within a very short time period, the prices
might increase in the short run, but if the software development is counted
as long-term investment, then its effect on prices is almost negligible. At the
same time, additional costs may arise from the need to hold a larger supply
of 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 of
cost is the cost of training of personnel (getting to know the new currency,
managing cash in the period of parallel circulation, becoming acquainted
with new software, etc.). In sum, relying on the experience of the adoption of
the euro in 2002, these other direct costs related to the cash changeover
may 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 be
sumer psychology that, given the wide variety of goods, consumers cannot                                                                 triggered by marketing
possibly remember or compare all prices. The main assumption behind psy-                                                                 policy of a firm
chological pricing is that consumers tend to ignore the last numbers on the
price tags in order to simplify price comparisons, rather than rounding them
to 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 price
drops by one euro from EUR 100 to EUR 99, as opposed to cases where the
price 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 extremely

unstable 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, they

should return the change in euros only.




Discussion Paper No. 24  June 14, 2011                                                                                                                        7
retailers may not change prices (according to changes in costs) on a current
basis, 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 zero
indicates something expensive; therefore, in the case of luxury goods, prices
ending in a zero might prove more suitable.

Thus, in sum, the price changes that might come from the changeover are            The transfer of those one
associated with imperfect markets and consumers’ irrational behaviour. If          time increases in costs
markets’ operations were optimal and consumers behaved rationally, there           into consumer prices is
would 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 markets
share, 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 about
price changes and what are the main factors behind the change in percep-
tions in times of currency changeover.


4. Inflation perception - psychological factors behind it
It 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               sumer
perceived inflation is positively correlated with price increases of frequently
purchased goods.18 The magnitude of perceived inflation is, in addition to the
frequency of purchases, influenced by different psychological factors. And
these 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 we
currency that was previously in circulation. On the one hand, nominal values       perceive the new value
of both currencies are different and this could affect the perception of prices    of exchange
and wages. But, on the other hand, there was not only a change in the
nominal value of money – the whole system was changed from a national to
single currency system. This kind of loss of national autonomy and increase
in interdependence with other countries could have influenced the attitude
towards the euro, and this attitude, in turn, affected the perception of wages
and prices.

The introduction of the euro is associated with the following different
factors:19 (a) the symbolic meaning of money; (b) how people learn,
memorize, and process information; (c) how people judge and make
decisions; (d) what are the current expectations, concerns, and beliefs of
citizens (consumers); and (e) how attitudes are changed by propaganda and
communication.

Symbolic meaning of money. The introduction of a new currency is much              National currency has
more than a change from one unit to another. For example, a national               two meanings: symbolic
currency has two meanings: symbolic and economic. The best way to see              and economic
this, is to look at the physical appearance of a coin – first meaning, as is
usually shown on one side of the coin, expresses the symbols of authority
and 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 of
exchange” in economic transactions. These two sides are very intimately
connected.



18 ECB (2002).

19 Burgoyne et al. (1999).




8                                                                  Discussion Paper No.24  June 14, 2011
It has been found that the subjective value of a currency is influenced by an        Perceptions are affected
                                                          20
individual’s net income and attitudes towards currency. But there is also            by the attitude towards
evidence that people remember the inflation rate and use these memories in           currency
building their attitude towards the currency. For instance, in Poland people
derived greater appreciation from winning a prize in new zlotys than in old
zlotys. The latter was, in people’s minds, associated with high inflation. After
the introduction of the new zloty, people no longer preferred dollars – the
new zloty was much more stable than the old zloty. This means that the
attractiveness of the money is determined by the attitudes of individuals.

Nonetheless, the difficulties of getting public acceptance and trust are likely
to be compounded in the case of the euro, where all aspects of the unit of
currency will change: its physical appearance, its name, its value and its
various denominations.21 There will also be very few aspects of
“associability” connecting the old currency to the euro. With the new
currency, public understanding may be aided if links are drawn with
exchange rates to other relatively familiar currencies. For instance, if the
euro had been adopted in the UK, it would have been worth approximately
70 pennies. 22 In that case, a conversion to dollars may be helpful. It should
be noted that elderly people, in particular, tend to persist in having significant
difficulties converting to the new money.

Learning, memorizing, and processing information. People’s opinion about             The way we learn affects
their 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 currency
necessary in order to learn something. In some cases, this is true (e.g., re-        in circulation has
membering telephone numbers); however, if a huge amount of numbers is                changed
involved, this cannot be true – we live in era when everyone has several
passwords, 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 need
to educate the public, it seems useful to look for some insights from cognitive
psychology as suggested in Burgoyne et al. (1999) to identify how people
                                                                 24
learn, process, represent, remember, and retrieve information. To sum up,
one may say that the relevant information should be presented in a way that
is compatible with people’s existing habits and schemata (organised bodies
of knowledge).25

In 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 in
assessing 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             rency
was directed to the general public was concentrated in the two-month run-up
to 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 helpful
in addressing the public’s needs.26

It 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 was
predominantly positive, while the attitude in northern-central countries such
as the Netherlands, the UK, and Germany was more reserved.27 Since

20 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
money is an important parameter of national identity, the southern European
countries seem to express it more through cultural and historical
achievements, while northern-central countries place their pride in their
national economic situations.28 These attitudes could be seen to agree with
social identity theory, according to which nations define their social identity
through dimensions in which they fare better than others. This might help us
to understand why those countries that are prouder of their culture and
history than their economic situation are more likely to favour the euro. One
can assume that the introduction of a single currency does not jeopardise
their national identity and self-esteem. Meanwhile, countries that define their
national identity through economic factors may fear that, with the introduction
of 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              tions
symbol, standing for a successful history of currency stability, a high reputa-
tion in foreign countries, and rising and stable prosperity in Germany. The
German 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 in
Germany goes hand in hand with economic identity, which, in turn, provides
the perception of a positive distinctiveness in comparison with other
nations.29

Judgement and decision making. Even if people wish to use all the                   People are not always
information 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 of
all the information available in an accurate way and then combine it in the
most rational manner to reach an optimal solution. Instead, people observe
the way information is served (the “framing effects”) and compare that with
other aspects of information presented at that time, including the channel of
communication (the “context effect”).

In the case of a currency changeover, the information people do need
concerns the price level change. A potential problem for accepting a new
currency involves the above- mentioned “money illusion.” Most of the
economic transactions are represented in nominal terms, and, therefore, it
seems likely that people often perceive and think about economic problems
in nominal terms, which may induce a "money illusion".

People could make the right decisions if there were no inflation, which is a
disorienting factor.31On this account, one might think that the elimination of
inflation should eliminate "money illusion" and regenerate rational behaviour.
However, since "money illusion" affects wage cuts and nominal prices in
separate ways, the effects of "money illusion" are likely to extend to
noninflationary settings.32

In Shafir et al (1997) show that in recent research in cognitive psychology
the different representations of the same situation may lead to systematically
different outcomes. For example, a choice between risky prospects may be
represented either in term of gains or losses, which seems natural to most
people, or in terms of final assets, as recommended by normative theory.33

28 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
Another example includes the undue influence of sunk costs and the
                                                                    34
underweighting of opportunity costs relative to out-of-pocket costs.

Another effect that is associated with judgement and decision-making is the       "Anchors" are widely
anchoring effect, which may, like money illusion, appear as a result of the       used
difference in nominal values. People tend to compare familiar prices with
other prices and then use these comparisons to form their opinions about
prices or price changes. One can call these reference prices “anchors.”
Thus, if the prices of these anchors rise, then the individual will perceive
higher inflation. Such anchors have a systematic influence on subsequent
judgements in that, for example, higher-priced anchors lead to higher price
estimations.35 In general, anchoring effects are defined as “the assimilation
                                                  36
of a judgement of salient standard of comparison.”

With regard to money, several lines of research have documented how price
estimations systematically deviate in the direction of such anchors, and how
the perception of prices systematically depends on the value of these
anchors.

In bargaining research, it is well known that the first offer serves as an
anchor that systematically affects the height of the first counteroffer.37 For
example, if people are confronted with a high price for a product and,
subsequently, this price is lowered to a more moderate price, they are more
willing to buy the good than if they are confronted with the moderate offer at
the beginning. This can be explained by the fact that the first price serves as
a reference price and influences the perception of the subsequent moderate
price via an anchoring effect.38

Since people are familiar with nominal values in their former, national
currency, these familiar values might be automatically salient and serve as
an anchor if people consider new prices or salaries in euros. As a
consequence, if the former national currency has lower nominal values than
the new currency (this is the case only for the Irish pound), the lower anchor
values would decrease price estimations. If, however, the former currency
has higher nominal values than the euro (the case of most countries in the
euro area) from the anchoring effect, one could expect an opposite result.39

Aside from these effects caused by the changes in nominal values, the
change of the money system itself from a national to an international, pan-
European currency could have an impact on processes such as the
perception of salaries and the estimation of prices. As stated above, people
can have different attitudes towards the new currency, and these can
influence the perception of money in general and processes like the
estimation 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 developments
ing more significant than equivalent gains, people tend to estimate their per-    more
sonal losses and gains compared with these anchors. Furthermore, because
losses seem much bigger than gains relative to the anchor point, it can be
that people perceive more losses than gains when a new currency is
introduced (even when, in absolute terms, the changes are equal). This
situation can be the cause of economic or symbolic conditions:40 (a) it seems

34 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
that most of the benefits are expected to accrue to those in finance and
business; and (b) instead of a national currency with all its symbolic
referents, people have to deal with the potentially “faceless” euro. So, it is
probable 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 keenly
as a loss, than any equivalent gain from “rounding down” in favour of the
buyer.

But even if prices were calculated correctly, customers tend to perceive them                                                           Perception of price
as 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 currency
overestimated 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                                                            nomic
by the strength and character of their attachment to their national identity.
Just as money can be seen to have two “sides” - economic and symbolic - it
may also be a part of national pride. The latter refers to cultural/sentimental
attachment to symbols of nationhood such as the royal family in the UK, as
well as a more instrumental attachment based upon the perceived benefits
of citizenship.41 The strongest direct influence on anti-euro sentiment is the
cultural dimension of attachment, with the effects of instrumental attachment
being moderated by the perceived benefits of adopting the euro.42

As was stated above, the attitude towards the euro is affected by how
people felt about their own currency – the deutsche mark was much more
appreciated then the euro. Even US dollars seemed, from the point of view
of 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 in
make people accept the euro. This is to a large extent the case in Estonia as                                                           Estonia was a symbol of
well. Estonians saw themselves as belonging to an independent nation when                                                               national independency
they introduced the kroon. After the collapse of the Soviet Union, the three                                                            and sovereignty
Baltic countries introduced their own national currencies – this made people
understand that these countries were independent and sovereign states. For
that reason, we believe, that, in the case of Estonia, the attitudes towards
the euro are substantially influenced by national identity, which is determined
through the national currency.43

Propaganda, communication, and attitude change. The literature dealing                                                                  Educating people using
with propaganda, communication, and changing attitudes is a “two-edged                                                                  mass media might act
sword”: some of the literature argues about tactics of mass communication                                                               like a "two-edged sword"
and persuasion and the susceptibilities of populations to persuasion, while
another branch of the literature deals with protecting the consumer. On the
one hand, one may wish to ensure that citizens participating in a democratic
process are as fully informed as possible, and that people have equal
opportunities to learn about the new currency. On the other hand, one
doesn’t want to make consumers victims of hype and half-truths propagated
by politicians.

People’s demand for information can be addressed by applying suggestions
from research on communication models.44 The “communication


41 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
45                                     46
organization” approach      and “innovation-diffusion theory”     say that
communications are most effective when both the mass media and
interpersonal channels are used. The mass media will be most useful in
providing information and generating knowledge about the euro. This
foundation can be built upon using existing social networks and
interpersonal contacts. A greater impact on attitudes will come from small
group discussions about the impact of the euro on the local community,
conducted by opinion leaders and esteemed figures in the community.47


5. Inflation perception, expectations, and actual inflation
in euro area countries after euro adoption
                                                                                     Perceived inflation is
Perceived inflation can be defined as consumers’ own rate of inflation, pro-
                                                                                     measured using mainly
duced, for instance, by the media or personal experience. According to this
                                                                                     survey results
definition, it can hardly be objectively measured. Most of the research uses
the Consumer Confidence Barometer survey, conducted by the European
Commission; this survey, which is carried out every year, includes all EU
member states and thus gives us the opportunity to compare different coun-
tries’ inflation perceptions. Usually the measure of perceived inflation is
given as the percentage change between respondents who say that prices
have risen and those who believe that prices have fallen. Another way to
calculate perceived inflation is to estimate it from survey results, but this
process is subject to restrictive assumptions.

The exact wording of the question in the consumer survey is “How do you
think 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 the
following 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 the
share of those who think prices have risen is 20 percentage points higher
than the share of those who think the opposite. The problem here is that a
measure like this is not directly comparable with actual inflation.

In addition, the perceived inflation found in surveys can be calculated as the
perceived inflation rate. According to Berk (1999) and Forsells and Kenny
(2002), the perceived inflation rate is calculated as follows. The inflation rate
perceived by people is, by assumption, normally distributed with a certain
mean 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 the
perceived 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 the
mean and the variance of the distribution in request. In order to calculate the
mean of the distribution, one then has to assume that the mean of perceived
inflation equals the mean of the statistically measured inflation rate. The
mean of the distribution estimated in this way is interpreted as the inflation

45 See Rothman (1974).

46 See Rogers (1983).

47 Burgoyne et al (1999).




Discussion Paper No. 24  June 14, 2011                                                              13
rate perceived by the general public. All in all, this estimation procedure de-
pends on several assumptions, the plausibility of which may certainly be
questioned.

                                                                                                                                        We observe prices of
The pioneering works of Kahneman and Tversky (1979) shows that the per-
                                                                                                                                        goods and services that
ception 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 effect
buys something. And she will perceive inflation more powerfully when the
goods she buys have become significantly more expensive. But, on the
other hand, she will barely notice price changes of goods she rarely buys.

                                                                                                                                        Another way to measure
Another way to measure perceived inflation is by an index.48 There are dif-
                                                                                                                                        inflation perception is to
ferent effects (loss aversion and isolation effect49) that need to be taken into
                                                                                                                                        calculate consumer price
account, 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 of
which the consumer buys each of the goods concerned.                                                                                    purchases

This index actually differs from the consumer price index, since this one in-
cludes primarily everyday goods that are purchased frequently (in CPI, the
frequencies 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 accorded
the same average value and the same scale as the harmonised index of
consumer price (HICP) inflation:


 itP 
           B  it Bi     
                      S i   i ,
                S Bi


where        itP is perceived inflation quantified for country i in period t.  i and
S i are, respectively, the average and the standard deviation of HICP infla-
tion, while Bi and SBi are the corresponding statistics for the balance of
opinions for country i. The averages and standard deviations are calculated
over 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 period
from 1995 until 2001 is used (they adopted the euro on January 1, 2002); for
Slovenia, the period lasts until the end of 2006; for Malta and Cyprus, until
the end of 2007; and, for the Slovak Republic, until the end of 2008. Last but
not least, for Estonia the period lasted until the end of the 2010.51 For the
sake of having a control group, we set up the group of countries that haven’t
adopt the euro – the United Kingdom, Sweden, Latvia, Lithuania, the Czech
Republic, 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 in2002

and 2001, respectively. Therefore, one may consider leaving these two out of the analysis.




14                                                                                                             Discussion Paper No.24  June 14, 2011
Euro area actual and perceived inflation rate (in percent)
5%
           HICP, yoy
           perceived inflation, yoy
4%


3%


2%


1%


0%


-1% Source: Eurostat, ECFIN, author's calculations
        1996     1998     2000       2002      2004   2006    2008     2010

We are aware that all these countries differ in terms of the structure of the
economy and the level of development, but in respect to the problem of in-
terest, similar factors may influence the perception of price changes in the
euro area as well as in non-member countries. As we are dealing with rather
different 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, and
Romania); 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 by
of the OMS, the data series of perceived inflation usually started in 1995, ex-     Eurostat and ECFIN
cept for Finland and Austria (data for both are available since 1996) and for
Luxembourg. The latter is quite exceptional – the survey data are available
only since 2002, and, therefore, Luxembourg is left out of this analysis. The
HICP is available only from 1996 onwards. In terms of testing the above-
mentioned assumption that the relationship of perceived and actual inflation
is stationary around the constant, we use the unit root test. For the OMS, the
data 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 on
the Lithuanians’ perceived inflation are available only since May 2001; in the
CEEC group, the same holds for Bulgaria, Romania, and Poland; and, in the
NEAC 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 in
actual inflation rate and used the unit root test to test for stationarity before    selected countries
the adoption of the euro (in the case of euro area countries); after that, we
looked at the same difference for the whole sample. This allows us to com-
pare both tests and to check whether the relationship between these two
changes significantly. Results of the tests are presented in Table 1 in Ap-
pendix. Under the null hypothesis, the difference is nonstationary, i.e., it is
assumed to have a unit root. We reject the null hypothesis at the level of
10% (the p-value should be less than 0.1) for most of the countries (except
for Finland, Ireland, and the Netherlands) for the pre-euro period; in this



Discussion Paper No. 24  June 14, 2011                                                              15
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 the
Netherlands in the past, which, in turn, indicates that the instability problem
for the more recent period is irrelevant. For all other euro area countries, the
null hypothesis is rejected, which means than one can agree that there was
a 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 cash
Austria, France, Greece, and the Netherlands. Since the latter country had a        changeover on people's
nonstationary relationship before euro adoption as well, we do not discuss it       perceptions will vanish
any further. This is a bit different result from Jemec’s (2010), who found that     gradually
most of the euro area countries had nonstationary relationships between
perceived and actual inflation for the whole period (until August 2009). Our
evidence shows that the effect of the euro cash changeover will vanish, and
that the stationary relationship between perceived and actual inflation will
remain in place. Even though the relationship will remain stationary in the
long run, the gap between perceived and actual inflation did widen shortly
after the euro cash changeover (see graphs in the Appendix), and the tests
taken 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 remains

The other question that arises in the literature is whether changes in per-         Granger causality tests
ceived 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 variable
tests (see results in Appendix, Table 2), which are usually applied to test cer-    has to predict the other
tain relationships between variables. In this paper, the variables are per-
ceived, expected, and actual inflation in selected countries. The test results
may 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 to
predict the other. The null hypothesis is that variable A does not Granger
cause variable B, which means that, if we can reject the null hypothesis,
there is a relationship between variables. The tests, the results of which are
presented in the Appendix, are run using stationary variables (monthly
growth 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 among
variables. Monthly changes in actual inflation cause changes in expectations        countries
in Germany and changes in perceptions in Austria, Italy, and Slovenia. It
would not be surprising to find this relationship to be more widespread as,
according to the questionnaire, the inflation perception indicator should be
explained by consumer price inflation, and expected inflation should also be
related 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 actual
inflation rate is determined by expectations. It is rather interesting that
changes in expectations have effects on monthly changes in inflation per-




16                                                                  Discussion Paper No.24  June 14, 2011
ceptions in so many countries. The relationship between monthly changes in
expectations and monthly changes in inflation perceptions is not so clear,
but they are closely related. This is partly explained by the experimental
psychology literature,52 and, as pointed in Jemec (2010), the influence of in-
flation perceptions on inflation expectations is explained by the rigidity of the
human 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 many
countries.

A monthly change in perceived inflation affects monthly changes in actual
inflation, according to the tests in Ireland, the Netherlands, Sweden, and
Slovenia. In the case of Slovenia, the relationship goes both ways – changes
in actual inflation cause changes in inflation perceptions and vice versa.


6. What will it be for Estonia? Short discussion of the
Estonian case
                                                                                    The same factors affect
Estonia is now facing the question of whether the changeover will bring
                                                                                    Estonians’ perceptions
about a considerable price increase. One may assume that, as in the euro
                                                                                    as in other euro area
area, some of the regular price changes might be timed for the changeover           countries
period because of the menu costs in Estonia, as well as the other euro area
countries. However, many entrepreneurs have agreed not to increase prices
(the Agreement of Honest Pricing, or Ausa Hinnastamise Lepe), and there
has been no evidence yet that they have not kept their part of the deal. At
the same time, expense arguments might have a more significant impact on
the prices of certain goods and services (price increases are allowed if they
are economically justified), and therefore the price rise might be associated
with the new currency in circulation. The actual price changes are, as de-
scribed in economic theory, influenced by competition on the market – the
tighter the competition, the less likely prices will increase due to the change
of currency in circulation. Knowing that Estonia is a well-functioning market
economy,53 the euro adoption should not have a significant inflationary im-
pact on price levels in Estonia (according to the recent study by Eurostat, the
effect of euro cash changeover on Estonian price level is 0.2-0.3 percentage
points54). 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 euro
area 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 prices
On the basis of the experience of countries that have already adopted the
                                                                                    change due to different
euro, it cannot be ruled out that the Estonian population might perceive the
                                                                                    reasons, but people
rise in prices to be higher than the actual price growth; this may be caused        might associate it with
by different factors (like the food price increase that will be associated with     euro adoption
the 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 of
those consumers who felt that prices were increasing faster, grew. Percep-
tions after the euro cash changeover will most probably rise, as seen in the

52 See, for instance ,Traut-Mattausch et al (2004), among others.

53 Lättemäe (2005).

54 Compliance Monitoring Information Note for Estonia




Discussion Paper No. 24  June 14, 2011                                                              17
experience of other euro area countries. It might happen that increases in
prices in certain fields (e.g., electricity and public transport) will be more
marked than the more modest price increases (or even declines) of some
goods in the basket of goods and services, as people have different con-
sumer baskets; moreover, as mentioned above – people observe the prices
of those goods that they purchase more often and do not take into account
the price falls of those goods they seldom if ever buy, but which are taken
into 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 circulation
should not be large. Prices have been rising, and it might very well be the
case that people in Estonia will correlate the current price rise with the new
currency. As is said in the relevant literature – it is not wrong how people
perceive inflation, since every household has a different consumer basket,
which hardly coincides with the average consumer basket calculated by the
Statistical Office. Additionally, people observe prices in isolation and re-
member only the prices of a few products/services; if those prices have
changed, they amend their perceptions accordingly. And as mentioned
above, if people make mistakes in calculating prices into kroons, they tend
not to correct them if these miscalculations coincide with their beliefs about
the 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. Conclusion
The discussion about inflation perception and euro adoption has been quite
intense in recent years, with most of the papers dealing with the first wave of
currency changeover (in 2002). We discuss currency changeover a bit more
broadly, considering the reasons behind price increases in times of no
shocks and in times of shocks such as a change of currency in circulation.
Discussing the relationship between actual and perceived inflation, one
needs to explain why people may change their opinions about price in-
creases after the country has adopted a new currency. The psychological
factors behind adopting a new currency and inflation perceptions have also
described in this paper.

The first part of the paper is devoted to the topic of price changes, i.e., why
prices change during so-called stable economic development. We then
turned to the reasons why prices change after a shock like a currency
changeover. From the literature, we found that prices tend to be rather
sticky, and on average prices change once a year (this frequency differs
among different groups of goods and services). According to a survey con-
ducted in Bank of Estonia, the price-setting behaviour of Estonian firms does
not differ much from their euro zone counterparts (except that competition is
said to be perceived as stronger than in the euro area).

But what about the factors that, in addition to regular factors, influence price
changes in times of currency changeover? As is known in the case of perfect
competition and with rational consumers, the change in the tool of exchange
should 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 by
money illusion – observing only the nominal value of the currency, they
therefore may overlook their consumption habits. Firms are, however, facing
different costs during the currency changeover, like the need to change price



18                                                                 Discussion Paper No.24  June 14, 2011
tags (menu costs), IT costs, the need for larger amounts of cash during the
period 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 the
main reason behind the price rise). Besides, the price changes may also be
affected 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 after
currency changeover. The way people learn, memorize, or identify them-
selves – all this has an impact on the perception of price changes. The tool
of consumer psychology is useful in understanding this phenomenon.

In the empirical analysis, we analysed the euro area countries together with
other EU countries, in order to add non-euro area countries as a control
group. Our findings show that there is a stationary relationship between ac-
tual and perceived inflation in most of the countries before 2002 (before the
first wave of the euro cash changeover), which indicates that people tend to
perceive price changes in a stable environment quite rationally. After the
euro cash changeover, as was found in other similar papers, the picture
changes somewhat – perceived inflation was much higher than actual infla-
tion. The gap between these two persisted until 2008, when both started to
move similarly again. Our test results for the whole period show that in most
of the countries the stationary relationship between actual and perceived in-
flation remained. Many papers that use shorter time series show much more
persistent results of breaking the stationary relationship between actual and
perceived inflation after the currency changeover. One may say that, shortly
after the changeover, the gap between perceived and actual inflation did
widen for some years and, after that, actual inflation began to catch up with
the perceptions; this might indicate that people’s beliefs about price changes
self-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 causality
tests show a rather strong interrelationship between expectations and per-
ceptions, which one may explain by the rigidity of the human mind. Effects of
changes in perceived inflation on actual inflation were evident in only a few
countries (Ireland, the Netherlands, Sweden, and Slovenia). At the same
time, 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 euro
adoption have been of faster inflation accompanying the euro cash change-
over (which, in turn, has gained a lot of media attention – the price increases
have been discussed more thoroughly than price decreases, if the latter
have been discussed at all). The reasons behind this fear are mostly psycho-
logical, but this does not decrease the need for their serious consideration
and for the dissemination of unbiased and relevant information on inflation
issues. Relying on the euro area experience, the euro cash changeover may
not necessarily bring about a crucial price increase or acceleration of infla-
tion, but the changes may be more pronounced in the prices of everyday
goods, and, therefore, perceived inflation may increase.




Discussion Paper No. 24  June 14, 2011                                            19
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22                                                                Discussion Paper No.24  June 14, 2011
Appendix 1
Table 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 countries
Austria                                           0.0461        10       0.2163      13
Belgium                                           0.0373        10       0.0435      13
Cyprus                                            0.0049        11       0.0012      12
Germany                                           0.0005        10       0.0626      13
Ireland                                           0.1573        10       0.0965      12
Spain                                             0.0313        10       0.0417      13
Finland                                           0.1994        10       0.0969      13
France                                            0.0499        10       0.1434      13
Greece                                            0.0471        10       0.3982      13
Italy                                             0.0090        10       0.0002      13
Malta                                             0.0035        10       0.0313      11
Netherlands                                       0.4485        10       0.1721      13
Portugal                                          0.0717        10       0.0214      13
Slovak Republic                                   0.0015        12       0.0008      13
Slovenia                                          0.0004        12       0.0078      13
                                                           Non-euro area countries
Bulgaria                                           (series too short)     0.0613     12
Denmark                                           0.0135         10       0.0002     13
Czech Republic                                    0.0761         10       0.0281     13
Hungary                                           0.2054         10       0.0430     13
Estonia                                           0.0799         10       0.0089     13
Latvia                                            0.0003         10       0.0006     12
Lithuania                                        (the series too short)   0.0246     12
Poland                                           (the series too short)   0.2424     12
Romania                                          (the series too short)   0.0062     12
Sweden                                            0.0402         10       0.0000     13
United Kingdom                                    0.1112         10       0.0015     13




Discussion Paper No. 24  June 14, 2011                                                       23
Table 2. Results of the Granger causality tests



Inflation does not Granger cause inflation expectations
                                                          Germany       2     177     2.61959   0.0757
                                                                        6     173     2.17734   0.0478
                                                                       12     167     1.98448   0.0297
Inflation 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   0.0914
Inflation 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   0.0297
Inflation 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   0.0635
Inflation perceptions does not Granger cause inflation
expectations
                                                          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   0.0001




24                                                                          Discussion Paper No.24  June 14, 2011
Inflation expectations does not Granger cause inflation
perceptions
                                                          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     0.0009




Discussion Paper No. 24  June 14, 2011                                                                   25
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

  • 1. Discussion Paper No. 24  June 14, 2011 Perceived inflation after euro cash changeover: the case of Estonia The adoption of euro has been accompanied by a larger increase in inflation perceptions than actual inflation developments. The wedge between those two has widened right after the adoption of euro in all euro area countries. On one hand, the explanation of the gap between actual and perceived inflation is related to the measuring of those rates – the indices reflect price changes differently. On the other hand, there is a bulk of ideas and theories related to the consumers’ ability to adapt new value of exchange: the attitude towards new currency, the role 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 a shock like change in value of exchange occurs. In the literature prices tend to be rather sticky during the stable economic development – the changes in prices occur only once a year on average. The currency changeover might influence the price level via costs – firms are facing different costs during the currency changeover, like the need to change price tags, related IT costs, 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 strategies as well as on the overall competition level in the sector. In addition, price changes may stem from the marketing strategies (for instance, psychological pricing). Even though the prices may be calculated correctly people tend to perceive higher prices compared to those in the national currency. In this paper we analyse different psychological factors that influence the perception of prices, like the way people learn, memorise or identify themselves or how they feel about the new currency. People tend, for example, calculate prices in euros back into national currency although the new currency has been in circulation for some time. The comparison with prices in national currency that was valid more than six months ago may be one of the causes behind the wedge between the actual and perceived inflation. In the empirical analysis we use data on euro area and EU countries and add some non-euro area 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 people tend 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. We conclude that the gap between perceived and actual inflation persisted for some years and within time disappeared again. We also analyse the causality between actual and perceived inflation rate using Granger causality test. The tests however will not show the magnitude or direction 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 show that the changes in perceived inflation may explain the changes in actual inflation in only few countries (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. 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 Paabut Acting Chief Economist at Swedbank Estonia Contents: Page: 1. Introduction 3 2. Price changes before and after euro cash changeover: price do change... 4 3. The presence of a shock: how does euro cash changeover affect prices? 6 4. Inflation perception - psychological factors behind it 8 5. Inflation perception, expectations, and actual inflation in euro area countries after euro adoption 13 6. What will it be for Estonia? Short discussion of the Estonian case 17 7. Conclusion 18 2 Discussion Paper No.24  June 14, 2011
  • 3. 1. Introduction The way people perceive In modern economic theory, the role of information has been central in de- inflation may have real scribing factors behind aggregate fluctuations and business cycles. This is effects especially 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 affects the aggregate level as well. In recent years, the discussion on inflation ex- pectations and inflation perception has been widespread and has focused on inflation perceptions after a currency changeover. In many cases, the euro cash changeover is associated with the so-called nimbus of price increase, and therefore it is thought that it might undermine the credibility of official price measures and/or adversely influence public opinion about the new cur- rency. In addition, perceived inflation may have real effects. For example, if consumers’ overestimation of inflation results in an underestimation of their purchasing 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 will cut back on consumption. In addition, perception may carry over to expecta- tions. The experience of Austria2 shows that, until the end of 1999, inflation expectations were slightly lower than perceived inflation; from 2000 to 2002, both rates were almost identical. However, the picture changed after Austria adopted the euro in 2002. Perceived inflation was approximately 1.5 per- centage points higher on average until 2003, after which expected inflation was revised significantly upwards (both expected and perceived inflations were brought together). Expectations play impor- In economic theory, inflation expectations have an important role to play. Ac- tant role in economic cording to Phelps’s and Friedman’s work on the augmented Phillips curve, theory expected inflation is one of the most important determinants of actual infla- tion.3 Friedman (1968) said that the Phillips curve relationship is valid only in short 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 and unemployment disappears. More recent studies on Phillips curve (see for in- stance Clarida et al (1999) and Blanchard and Gali (2007)) are related to the New Keynesian dynamic stochastic general equilibrium models, where the prices are assumed to be sticky. Like the expectations augmented Phillips curve, the New Keynesian framework also states that the relationship be- tween inflation and unemployment is temporary and increased inflation may reduce unemployment only in the short run, but not permanently. Real business cycle theory says that, according to the theory of the natural rate, 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 in inflation will affect real variables like output and unemployment. Many papers have found that the wedge between perceived and actual price changes has widened in the euro area, especially after the introduction of euro banknotes and coins; at the same time, the newest papers show that in nonexceptional circumstances people perceive inflation rationally and their perceptions and expectations become exaggerated in the case of shock 1 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 (e.g., currency changeover). In sum, one may divide the relevant literature into three groups. The first group deals with consumers’ perception of prices of the most frequently purchased goods and services.5 The second group of papers 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 euro adoption. 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.) 80 3% 60 2% 40 1% 20 0% 0 Source: ECFIN, Eurostat -1% -20 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 In this paper, we first briefly discuss the reasons why prices change during a currency changeover. The third chapter deals with inflation perception and the psychological factors behind it during euro adoption. Then we discuss price perception, expectations and actual inflation after euro cash change- over in euro area countries (the analysis covers period from 1997 (or later depending on the data availability) till 2010). And we conclude with a short discussion on the Estonian case. As Estonia has adopted the euro only quite recently (in January 2011), we do not have enough data for a deep analysis of 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 for to be more responsive to changes in the costs of intermediate inputs to pro- different reasons duction than they are to changes in demand. Or, put differently, changes in costs seem to be more the reason that prices change than changes in markups. However, even in so-called customer markets, prices can change quite 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. At the 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. According to Cecchetti (1985, 1986), the average time between price changes 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 high inflation in the 1970s.8 Carlton (1986) analysed manufacturing firms in the US and found that the time between price changes varies from 1½ years for steel and chemicals to ½ year for plywood and nonferrous metals. This means that pricing behaviour differs among industries. Blinder (1994) and Blinder 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 per year, 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 the prices 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 important implication of their work is that the frequency of price changes differs dramatically across goods (their study covers 350 categories of goods and services, which is about 70 percent of consumer spending and was based on unpublished data from the Bureau of Labour Statistics for 1995-1997). For instance, some prices seldom change: prices of newspapers, men’s haircuts, and taxi fares change in fewer than 5% of the months covered. But, at the same time, some prices change very frequently, with prices of gasoline, tomatoes, and air fares changing in more than 70 % of the months.9 According to Cecchetti (1986), who studied newsstand prices of 38 Ameri- can magazines over 1953-1979, the time between price changes varied from 1.8 to 14 years. However, Bils and Klenow (2004) find that magazines (including subscription as well as newsstand prices) exhibit price changes on average every 11 months. And, more important, magazines prices are at the stickiest end of the spectrum, i.e., 86% of nonhousing goods prices change more frequently.10 The other branch of rather sticky prices is the prices of meals in restaurants. 11 According to different studies, restaurant prices are the stickiest. But, in the case of shocks (such as the euro cash changeover) these prices tend to increase more than in other sectors, since entrepreneurs will try at least some 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, Estonian entrepreneurs change the prices of their main product/service once per year.12 Recall from university economics lectures – prices do change and the change is affected by different factors. For instance, if prices of inputs increase, then there is a high probability that prices of final goods/services will increase as well. In addition, changes in prices are influenced by macroeconomic conditions, sectoral conditions (cost structure or degree of competition), 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. 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 had In the relevant literature, it has been found that the speed of this adjustment effect on prices is to a large extent determined by the beliefs of the entrepreneurs – if entrepreneurs believe that the change in input prices is temporary, and then the price of their product will not change. But what about price changes in case of the shocks like a currency changeover? According to Eurostat (2003) approximately 50% of goods prices followed the usual path of change in 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 had an impact on the prices of approximately 26% of goods groups.13 The price increase was most apparent in the case of restaurants and cafés, and hairdressers and beauty parlours, i.e., mainly locally provided services. Price increases in euro area (EA12) by different goods groups alcohol and tobacco 8% food hairdresser HICP restaurants and cafes 6% newspapers, books 4% 2% 0% Source: Eurostat 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 There are several reasons why a slight price increase accompanies the cur- rency changeover; they mostly depend on how well an average company can manage expenses arising from the changeover. From economic theory, we know that in the case of perfect competition, Price changes depend where 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 pricing penses, prices may temporarily increase. After writing off the expenses, the strategy company should return to the previous price level. Other countries’ experi- ence shows that the related extent of the price increase depends on the strength of competition in trade. The price increase appeared to be smaller in smaller shops and in those countries where retail trade concentration was lower. 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-time changeover are tied to price developments and replacement of price tags, costs related to the training of employees, accounting in several currencies during the period of change in currency parallel circulation, and, when necessary, purchases of new software.14 13 See also Lättemäe (2005). 14 Lättemäe (2005). 6 Discussion Paper No.24  June 14, 2011
  • 7. In addition to the one-off costs, there are factors that may give rise to one-off or 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 directly such as, in the case of currency changeover, the development of new prices, related to the price printing of price tags, and remuneration of extra working hours etc. As men- change process such as tioned 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 working riod. Thus, the menu costs directly related to the changeover in fact should hours etc decrease costs for the firm, but consumers perceive this as a price change due to the currency change. Such a pricing strategy is definitely trickier to implement when the media and public at large take more interest in the price changes. Money illusion is a bias in the assessment of the real value of transactions, People tend to observe induced by their nominal representations.15 In other words, money illusion prices in nominal values describes the phenomenon that people tend to observe nominal values, since the nominal value of money is salient and a natural unit: the price is low, when the nominal value of the good is low. Furthermore, money illusion influences international trade and tourism, or, as Fisher (1928) said: “almost everyone is subject to the ‘money illusion’ in respect to his own country’s currency. This seems to him to be stationary while the money of other coun- tries seems to change”16 There are also other expenses directly related to the euro cash changeover Firms need to spend on that 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 to the prices of goods/services will depend on the strategy firms use – if firm wants to depreciate the costs within a very short time period, the prices might increase in the short run, but if the software development is counted as long-term investment, then its effect on prices is almost negligible. At the same time, additional costs may arise from the need to hold a larger supply of 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 of cost is the cost of training of personnel (getting to know the new currency, managing cash in the period of parallel circulation, becoming acquainted with new software, etc.). In sum, relying on the experience of the adoption of the euro in 2002, these other direct costs related to the cash changeover may 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 be sumer psychology that, given the wide variety of goods, consumers cannot triggered by marketing possibly remember or compare all prices. The main assumption behind psy- policy of a firm chological pricing is that consumers tend to ignore the last numbers on the price tags in order to simplify price comparisons, rather than rounding them to 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 price drops by one euro from EUR 100 to EUR 99, as opposed to cases where the price 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 extremely unstable 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, they should return the change in euros only. Discussion Paper No. 24  June 14, 2011 7
  • 8. retailers may not change prices (according to changes in costs) on a current basis, 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 zero indicates something expensive; therefore, in the case of luxury goods, prices ending in a zero might prove more suitable. Thus, in sum, the price changes that might come from the changeover are The transfer of those one associated with imperfect markets and consumers’ irrational behaviour. If time increases in costs markets’ operations were optimal and consumers behaved rationally, there into consumer prices is would 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 markets share, 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 about price changes and what are the main factors behind the change in percep- tions in times of currency changeover. 4. Inflation perception - psychological factors behind it It 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 sumer perceived inflation is positively correlated with price increases of frequently purchased goods.18 The magnitude of perceived inflation is, in addition to the frequency of purchases, influenced by different psychological factors. And these 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 we currency that was previously in circulation. On the one hand, nominal values perceive the new value of both currencies are different and this could affect the perception of prices of exchange and wages. But, on the other hand, there was not only a change in the nominal value of money – the whole system was changed from a national to single currency system. This kind of loss of national autonomy and increase in interdependence with other countries could have influenced the attitude towards the euro, and this attitude, in turn, affected the perception of wages and prices. The introduction of the euro is associated with the following different factors:19 (a) the symbolic meaning of money; (b) how people learn, memorize, and process information; (c) how people judge and make decisions; (d) what are the current expectations, concerns, and beliefs of citizens (consumers); and (e) how attitudes are changed by propaganda and communication. Symbolic meaning of money. The introduction of a new currency is much National currency has more than a change from one unit to another. For example, a national two meanings: symbolic currency has two meanings: symbolic and economic. The best way to see and economic this, is to look at the physical appearance of a coin – first meaning, as is usually shown on one side of the coin, expresses the symbols of authority and 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 of exchange” in economic transactions. These two sides are very intimately connected. 18 ECB (2002). 19 Burgoyne et al. (1999). 8 Discussion Paper No.24  June 14, 2011
  • 9. It has been found that the subjective value of a currency is influenced by an Perceptions are affected 20 individual’s net income and attitudes towards currency. But there is also by the attitude towards evidence that people remember the inflation rate and use these memories in currency building their attitude towards the currency. For instance, in Poland people derived greater appreciation from winning a prize in new zlotys than in old zlotys. The latter was, in people’s minds, associated with high inflation. After the introduction of the new zloty, people no longer preferred dollars – the new zloty was much more stable than the old zloty. This means that the attractiveness of the money is determined by the attitudes of individuals. Nonetheless, the difficulties of getting public acceptance and trust are likely to be compounded in the case of the euro, where all aspects of the unit of currency will change: its physical appearance, its name, its value and its various denominations.21 There will also be very few aspects of “associability” connecting the old currency to the euro. With the new currency, public understanding may be aided if links are drawn with exchange rates to other relatively familiar currencies. For instance, if the euro had been adopted in the UK, it would have been worth approximately 70 pennies. 22 In that case, a conversion to dollars may be helpful. It should be noted that elderly people, in particular, tend to persist in having significant difficulties converting to the new money. Learning, memorizing, and processing information. People’s opinion about The way we learn affects their 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 currency necessary in order to learn something. In some cases, this is true (e.g., re- in circulation has membering telephone numbers); however, if a huge amount of numbers is changed involved, this cannot be true – we live in era when everyone has several passwords, 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 need to educate the public, it seems useful to look for some insights from cognitive psychology as suggested in Burgoyne et al. (1999) to identify how people 24 learn, process, represent, remember, and retrieve information. To sum up, one may say that the relevant information should be presented in a way that is compatible with people’s existing habits and schemata (organised bodies of knowledge).25 In 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 in assessing 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 rency was directed to the general public was concentrated in the two-month run-up to 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 helpful in addressing the public’s needs.26 It 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 was predominantly positive, while the attitude in northern-central countries such as the Netherlands, the UK, and Germany was more reserved.27 Since 20 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. money is an important parameter of national identity, the southern European countries seem to express it more through cultural and historical achievements, while northern-central countries place their pride in their national economic situations.28 These attitudes could be seen to agree with social identity theory, according to which nations define their social identity through dimensions in which they fare better than others. This might help us to understand why those countries that are prouder of their culture and history than their economic situation are more likely to favour the euro. One can assume that the introduction of a single currency does not jeopardise their national identity and self-esteem. Meanwhile, countries that define their national identity through economic factors may fear that, with the introduction of 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 tions symbol, standing for a successful history of currency stability, a high reputa- tion in foreign countries, and rising and stable prosperity in Germany. The German 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 in Germany goes hand in hand with economic identity, which, in turn, provides the perception of a positive distinctiveness in comparison with other nations.29 Judgement and decision making. Even if people wish to use all the People are not always information 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 of all the information available in an accurate way and then combine it in the most rational manner to reach an optimal solution. Instead, people observe the way information is served (the “framing effects”) and compare that with other aspects of information presented at that time, including the channel of communication (the “context effect”). In the case of a currency changeover, the information people do need concerns the price level change. A potential problem for accepting a new currency involves the above- mentioned “money illusion.” Most of the economic transactions are represented in nominal terms, and, therefore, it seems likely that people often perceive and think about economic problems in nominal terms, which may induce a "money illusion". People could make the right decisions if there were no inflation, which is a disorienting factor.31On this account, one might think that the elimination of inflation should eliminate "money illusion" and regenerate rational behaviour. However, since "money illusion" affects wage cuts and nominal prices in separate ways, the effects of "money illusion" are likely to extend to noninflationary settings.32 In Shafir et al (1997) show that in recent research in cognitive psychology the different representations of the same situation may lead to systematically different outcomes. For example, a choice between risky prospects may be represented either in term of gains or losses, which seems natural to most people, or in terms of final assets, as recommended by normative theory.33 28 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. Another example includes the undue influence of sunk costs and the 34 underweighting of opportunity costs relative to out-of-pocket costs. Another effect that is associated with judgement and decision-making is the "Anchors" are widely anchoring effect, which may, like money illusion, appear as a result of the used difference in nominal values. People tend to compare familiar prices with other prices and then use these comparisons to form their opinions about prices or price changes. One can call these reference prices “anchors.” Thus, if the prices of these anchors rise, then the individual will perceive higher inflation. Such anchors have a systematic influence on subsequent judgements in that, for example, higher-priced anchors lead to higher price estimations.35 In general, anchoring effects are defined as “the assimilation 36 of a judgement of salient standard of comparison.” With regard to money, several lines of research have documented how price estimations systematically deviate in the direction of such anchors, and how the perception of prices systematically depends on the value of these anchors. In bargaining research, it is well known that the first offer serves as an anchor that systematically affects the height of the first counteroffer.37 For example, if people are confronted with a high price for a product and, subsequently, this price is lowered to a more moderate price, they are more willing to buy the good than if they are confronted with the moderate offer at the beginning. This can be explained by the fact that the first price serves as a reference price and influences the perception of the subsequent moderate price via an anchoring effect.38 Since people are familiar with nominal values in their former, national currency, these familiar values might be automatically salient and serve as an anchor if people consider new prices or salaries in euros. As a consequence, if the former national currency has lower nominal values than the new currency (this is the case only for the Irish pound), the lower anchor values would decrease price estimations. If, however, the former currency has higher nominal values than the euro (the case of most countries in the euro area) from the anchoring effect, one could expect an opposite result.39 Aside from these effects caused by the changes in nominal values, the change of the money system itself from a national to an international, pan- European currency could have an impact on processes such as the perception of salaries and the estimation of prices. As stated above, people can have different attitudes towards the new currency, and these can influence the perception of money in general and processes like the estimation 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 developments ing more significant than equivalent gains, people tend to estimate their per- more sonal losses and gains compared with these anchors. Furthermore, because losses seem much bigger than gains relative to the anchor point, it can be that people perceive more losses than gains when a new currency is introduced (even when, in absolute terms, the changes are equal). This situation can be the cause of economic or symbolic conditions:40 (a) it seems 34 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. that most of the benefits are expected to accrue to those in finance and business; and (b) instead of a national currency with all its symbolic referents, people have to deal with the potentially “faceless” euro. So, it is probable 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 keenly as a loss, than any equivalent gain from “rounding down” in favour of the buyer. But even if prices were calculated correctly, customers tend to perceive them Perception of price as 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 currency overestimated 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 nomic by the strength and character of their attachment to their national identity. Just as money can be seen to have two “sides” - economic and symbolic - it may also be a part of national pride. The latter refers to cultural/sentimental attachment to symbols of nationhood such as the royal family in the UK, as well as a more instrumental attachment based upon the perceived benefits of citizenship.41 The strongest direct influence on anti-euro sentiment is the cultural dimension of attachment, with the effects of instrumental attachment being moderated by the perceived benefits of adopting the euro.42 As was stated above, the attitude towards the euro is affected by how people felt about their own currency – the deutsche mark was much more appreciated then the euro. Even US dollars seemed, from the point of view of 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 in make people accept the euro. This is to a large extent the case in Estonia as Estonia was a symbol of well. Estonians saw themselves as belonging to an independent nation when national independency they introduced the kroon. After the collapse of the Soviet Union, the three and sovereignty Baltic countries introduced their own national currencies – this made people understand that these countries were independent and sovereign states. For that reason, we believe, that, in the case of Estonia, the attitudes towards the euro are substantially influenced by national identity, which is determined through the national currency.43 Propaganda, communication, and attitude change. The literature dealing Educating people using with propaganda, communication, and changing attitudes is a “two-edged mass media might act sword”: some of the literature argues about tactics of mass communication like a "two-edged sword" and persuasion and the susceptibilities of populations to persuasion, while another branch of the literature deals with protecting the consumer. On the one hand, one may wish to ensure that citizens participating in a democratic process are as fully informed as possible, and that people have equal opportunities to learn about the new currency. On the other hand, one doesn’t want to make consumers victims of hype and half-truths propagated by politicians. People’s demand for information can be addressed by applying suggestions from research on communication models.44 The “communication 41 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. 45 46 organization” approach and “innovation-diffusion theory” say that communications are most effective when both the mass media and interpersonal channels are used. The mass media will be most useful in providing information and generating knowledge about the euro. This foundation can be built upon using existing social networks and interpersonal contacts. A greater impact on attitudes will come from small group discussions about the impact of the euro on the local community, conducted by opinion leaders and esteemed figures in the community.47 5. Inflation perception, expectations, and actual inflation in euro area countries after euro adoption Perceived inflation is Perceived inflation can be defined as consumers’ own rate of inflation, pro- measured using mainly duced, for instance, by the media or personal experience. According to this survey results definition, it can hardly be objectively measured. Most of the research uses the Consumer Confidence Barometer survey, conducted by the European Commission; this survey, which is carried out every year, includes all EU member states and thus gives us the opportunity to compare different coun- tries’ inflation perceptions. Usually the measure of perceived inflation is given as the percentage change between respondents who say that prices have risen and those who believe that prices have fallen. Another way to calculate perceived inflation is to estimate it from survey results, but this process is subject to restrictive assumptions. The exact wording of the question in the consumer survey is “How do you think 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 the following 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 the share of those who think prices have risen is 20 percentage points higher than the share of those who think the opposite. The problem here is that a measure like this is not directly comparable with actual inflation. In addition, the perceived inflation found in surveys can be calculated as the perceived inflation rate. According to Berk (1999) and Forsells and Kenny (2002), the perceived inflation rate is calculated as follows. The inflation rate perceived by people is, by assumption, normally distributed with a certain mean 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 the perceived 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 the mean and the variance of the distribution in request. In order to calculate the mean of the distribution, one then has to assume that the mean of perceived inflation equals the mean of the statistically measured inflation rate. The mean of the distribution estimated in this way is interpreted as the inflation 45 See Rothman (1974). 46 See Rogers (1983). 47 Burgoyne et al (1999). Discussion Paper No. 24  June 14, 2011 13
  • 14. rate perceived by the general public. All in all, this estimation procedure de- pends on several assumptions, the plausibility of which may certainly be questioned. We observe prices of The pioneering works of Kahneman and Tversky (1979) shows that the per- goods and services that ception 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 effect buys something. And she will perceive inflation more powerfully when the goods she buys have become significantly more expensive. But, on the other hand, she will barely notice price changes of goods she rarely buys. Another way to measure Another way to measure perceived inflation is by an index.48 There are dif- inflation perception is to ferent effects (loss aversion and isolation effect49) that need to be taken into calculate consumer price account, 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 of which the consumer buys each of the goods concerned. purchases This index actually differs from the consumer price index, since this one in- cludes primarily everyday goods that are purchased frequently (in CPI, the frequencies 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 accorded the same average value and the same scale as the harmonised index of consumer price (HICP) inflation:  itP  B it Bi  S i   i , S Bi where  itP is perceived inflation quantified for country i in period t.  i and S i are, respectively, the average and the standard deviation of HICP infla- tion, while Bi and SBi are the corresponding statistics for the balance of opinions for country i. The averages and standard deviations are calculated over 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 period from 1995 until 2001 is used (they adopted the euro on January 1, 2002); for Slovenia, the period lasts until the end of 2006; for Malta and Cyprus, until the end of 2007; and, for the Slovak Republic, until the end of 2008. Last but not least, for Estonia the period lasted until the end of the 2010.51 For the sake of having a control group, we set up the group of countries that haven’t adopt the euro – the United Kingdom, Sweden, Latvia, Lithuania, the Czech Republic, 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 in2002 and 2001, respectively. Therefore, one may consider leaving these two out of the analysis. 14 Discussion Paper No.24  June 14, 2011
  • 15. Euro area actual and perceived inflation rate (in percent) 5% HICP, yoy perceived inflation, yoy 4% 3% 2% 1% 0% -1% Source: Eurostat, ECFIN, author's calculations 1996 1998 2000 2002 2004 2006 2008 2010 We are aware that all these countries differ in terms of the structure of the economy and the level of development, but in respect to the problem of in- terest, similar factors may influence the perception of price changes in the euro area as well as in non-member countries. As we are dealing with rather different 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, and Romania); 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 by of the OMS, the data series of perceived inflation usually started in 1995, ex- Eurostat and ECFIN cept for Finland and Austria (data for both are available since 1996) and for Luxembourg. The latter is quite exceptional – the survey data are available only since 2002, and, therefore, Luxembourg is left out of this analysis. The HICP is available only from 1996 onwards. In terms of testing the above- mentioned assumption that the relationship of perceived and actual inflation is stationary around the constant, we use the unit root test. For the OMS, the data 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 on the Lithuanians’ perceived inflation are available only since May 2001; in the CEEC group, the same holds for Bulgaria, Romania, and Poland; and, in the NEAC 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 in actual inflation rate and used the unit root test to test for stationarity before selected countries the adoption of the euro (in the case of euro area countries); after that, we looked at the same difference for the whole sample. This allows us to com- pare both tests and to check whether the relationship between these two changes significantly. Results of the tests are presented in Table 1 in Ap- pendix. Under the null hypothesis, the difference is nonstationary, i.e., it is assumed to have a unit root. We reject the null hypothesis at the level of 10% (the p-value should be less than 0.1) for most of the countries (except for Finland, Ireland, and the Netherlands) for the pre-euro period; in this Discussion Paper No. 24  June 14, 2011 15
  • 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 the Netherlands in the past, which, in turn, indicates that the instability problem for the more recent period is irrelevant. For all other euro area countries, the null hypothesis is rejected, which means than one can agree that there was a 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 cash Austria, France, Greece, and the Netherlands. Since the latter country had a changeover on people's nonstationary relationship before euro adoption as well, we do not discuss it perceptions will vanish any further. This is a bit different result from Jemec’s (2010), who found that gradually most of the euro area countries had nonstationary relationships between perceived and actual inflation for the whole period (until August 2009). Our evidence shows that the effect of the euro cash changeover will vanish, and that the stationary relationship between perceived and actual inflation will remain in place. Even though the relationship will remain stationary in the long run, the gap between perceived and actual inflation did widen shortly after the euro cash changeover (see graphs in the Appendix), and the tests taken 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 remains The other question that arises in the literature is whether changes in per- Granger causality tests ceived 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 variable tests (see results in Appendix, Table 2), which are usually applied to test cer- has to predict the other tain relationships between variables. In this paper, the variables are per- ceived, expected, and actual inflation in selected countries. The test results may 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 to predict the other. The null hypothesis is that variable A does not Granger cause variable B, which means that, if we can reject the null hypothesis, there is a relationship between variables. The tests, the results of which are presented in the Appendix, are run using stationary variables (monthly growth 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 among variables. Monthly changes in actual inflation cause changes in expectations countries in Germany and changes in perceptions in Austria, Italy, and Slovenia. It would not be surprising to find this relationship to be more widespread as, according to the questionnaire, the inflation perception indicator should be explained by consumer price inflation, and expected inflation should also be related 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 actual inflation rate is determined by expectations. It is rather interesting that changes in expectations have effects on monthly changes in inflation per- 16 Discussion Paper No.24  June 14, 2011
  • 17. ceptions in so many countries. The relationship between monthly changes in expectations and monthly changes in inflation perceptions is not so clear, but they are closely related. This is partly explained by the experimental psychology literature,52 and, as pointed in Jemec (2010), the influence of in- flation perceptions on inflation expectations is explained by the rigidity of the human 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 many countries. A monthly change in perceived inflation affects monthly changes in actual inflation, according to the tests in Ireland, the Netherlands, Sweden, and Slovenia. In the case of Slovenia, the relationship goes both ways – changes in actual inflation cause changes in inflation perceptions and vice versa. 6. What will it be for Estonia? Short discussion of the Estonian case The same factors affect Estonia is now facing the question of whether the changeover will bring Estonians’ perceptions about a considerable price increase. One may assume that, as in the euro as in other euro area area, some of the regular price changes might be timed for the changeover countries period because of the menu costs in Estonia, as well as the other euro area countries. However, many entrepreneurs have agreed not to increase prices (the Agreement of Honest Pricing, or Ausa Hinnastamise Lepe), and there has been no evidence yet that they have not kept their part of the deal. At the same time, expense arguments might have a more significant impact on the prices of certain goods and services (price increases are allowed if they are economically justified), and therefore the price rise might be associated with the new currency in circulation. The actual price changes are, as de- scribed in economic theory, influenced by competition on the market – the tighter the competition, the less likely prices will increase due to the change of currency in circulation. Knowing that Estonia is a well-functioning market economy,53 the euro adoption should not have a significant inflationary im- pact on price levels in Estonia (according to the recent study by Eurostat, the effect of euro cash changeover on Estonian price level is 0.2-0.3 percentage points54). 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 euro area 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 prices On the basis of the experience of countries that have already adopted the change due to different euro, it cannot be ruled out that the Estonian population might perceive the reasons, but people rise in prices to be higher than the actual price growth; this may be caused might associate it with by different factors (like the food price increase that will be associated with euro adoption the 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 of those consumers who felt that prices were increasing faster, grew. Percep- tions after the euro cash changeover will most probably rise, as seen in the 52 See, for instance ,Traut-Mattausch et al (2004), among others. 53 Lättemäe (2005). 54 Compliance Monitoring Information Note for Estonia Discussion Paper No. 24  June 14, 2011 17
  • 18. experience of other euro area countries. It might happen that increases in prices in certain fields (e.g., electricity and public transport) will be more marked than the more modest price increases (or even declines) of some goods in the basket of goods and services, as people have different con- sumer baskets; moreover, as mentioned above – people observe the prices of those goods that they purchase more often and do not take into account the price falls of those goods they seldom if ever buy, but which are taken into 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 circulation should not be large. Prices have been rising, and it might very well be the case that people in Estonia will correlate the current price rise with the new currency. As is said in the relevant literature – it is not wrong how people perceive inflation, since every household has a different consumer basket, which hardly coincides with the average consumer basket calculated by the Statistical Office. Additionally, people observe prices in isolation and re- member only the prices of a few products/services; if those prices have changed, they amend their perceptions accordingly. And as mentioned above, if people make mistakes in calculating prices into kroons, they tend not to correct them if these miscalculations coincide with their beliefs about the 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. Conclusion The discussion about inflation perception and euro adoption has been quite intense in recent years, with most of the papers dealing with the first wave of currency changeover (in 2002). We discuss currency changeover a bit more broadly, considering the reasons behind price increases in times of no shocks and in times of shocks such as a change of currency in circulation. Discussing the relationship between actual and perceived inflation, one needs to explain why people may change their opinions about price in- creases after the country has adopted a new currency. The psychological factors behind adopting a new currency and inflation perceptions have also described in this paper. The first part of the paper is devoted to the topic of price changes, i.e., why prices change during so-called stable economic development. We then turned to the reasons why prices change after a shock like a currency changeover. From the literature, we found that prices tend to be rather sticky, and on average prices change once a year (this frequency differs among different groups of goods and services). According to a survey con- ducted in Bank of Estonia, the price-setting behaviour of Estonian firms does not differ much from their euro zone counterparts (except that competition is said to be perceived as stronger than in the euro area). But what about the factors that, in addition to regular factors, influence price changes in times of currency changeover? As is known in the case of perfect competition and with rational consumers, the change in the tool of exchange should 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 by money illusion – observing only the nominal value of the currency, they therefore may overlook their consumption habits. Firms are, however, facing different costs during the currency changeover, like the need to change price 18 Discussion Paper No.24  June 14, 2011
  • 19. tags (menu costs), IT costs, the need for larger amounts of cash during the period 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 the main reason behind the price rise). Besides, the price changes may also be affected 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 after currency changeover. The way people learn, memorize, or identify them- selves – all this has an impact on the perception of price changes. The tool of consumer psychology is useful in understanding this phenomenon. In the empirical analysis, we analysed the euro area countries together with other EU countries, in order to add non-euro area countries as a control group. Our findings show that there is a stationary relationship between ac- tual and perceived inflation in most of the countries before 2002 (before the first wave of the euro cash changeover), which indicates that people tend to perceive price changes in a stable environment quite rationally. After the euro cash changeover, as was found in other similar papers, the picture changes somewhat – perceived inflation was much higher than actual infla- tion. The gap between these two persisted until 2008, when both started to move similarly again. Our test results for the whole period show that in most of the countries the stationary relationship between actual and perceived in- flation remained. Many papers that use shorter time series show much more persistent results of breaking the stationary relationship between actual and perceived inflation after the currency changeover. One may say that, shortly after the changeover, the gap between perceived and actual inflation did widen for some years and, after that, actual inflation began to catch up with the perceptions; this might indicate that people’s beliefs about price changes self-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 causality tests show a rather strong interrelationship between expectations and per- ceptions, which one may explain by the rigidity of the human mind. Effects of changes in perceived inflation on actual inflation were evident in only a few countries (Ireland, the Netherlands, Sweden, and Slovenia). At the same time, 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 euro adoption have been of faster inflation accompanying the euro cash change- over (which, in turn, has gained a lot of media attention – the price increases have been discussed more thoroughly than price decreases, if the latter have been discussed at all). The reasons behind this fear are mostly psycho- logical, but this does not decrease the need for their serious consideration and for the dissemination of unbiased and relevant information on inflation issues. Relying on the euro area experience, the euro cash changeover may not necessarily bring about a crucial price increase or acceleration of infla- tion, but the changes may be more pronounced in the prices of everyday goods, and, therefore, perceived inflation may increase. Discussion Paper No. 24  June 14, 2011 19
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  • 23. Appendix 1 Table 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 countries Austria 0.0461 10 0.2163 13 Belgium 0.0373 10 0.0435 13 Cyprus 0.0049 11 0.0012 12 Germany 0.0005 10 0.0626 13 Ireland 0.1573 10 0.0965 12 Spain 0.0313 10 0.0417 13 Finland 0.1994 10 0.0969 13 France 0.0499 10 0.1434 13 Greece 0.0471 10 0.3982 13 Italy 0.0090 10 0.0002 13 Malta 0.0035 10 0.0313 11 Netherlands 0.4485 10 0.1721 13 Portugal 0.0717 10 0.0214 13 Slovak Republic 0.0015 12 0.0008 13 Slovenia 0.0004 12 0.0078 13 Non-euro area countries Bulgaria (series too short) 0.0613 12 Denmark 0.0135 10 0.0002 13 Czech Republic 0.0761 10 0.0281 13 Hungary 0.2054 10 0.0430 13 Estonia 0.0799 10 0.0089 13 Latvia 0.0003 10 0.0006 12 Lithuania (the series too short) 0.0246 12 Poland (the series too short) 0.2424 12 Romania (the series too short) 0.0062 12 Sweden 0.0402 10 0.0000 13 United Kingdom 0.1112 10 0.0015 13 Discussion Paper No. 24  June 14, 2011 23
  • 24. Table 2. Results of the Granger causality tests Inflation does not Granger cause inflation expectations Germany 2 177 2.61959 0.0757 6 173 2.17734 0.0478 12 167 1.98448 0.0297 Inflation 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 0.0914 Inflation 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 0.0297 Inflation 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 0.0635 Inflation perceptions does not Granger cause inflation expectations 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 0.0001 24 Discussion Paper No.24  June 14, 2011
  • 25. Inflation expectations does not Granger cause inflation perceptions 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 0.0009 Discussion Paper No. 24  June 14, 2011 25