A long-standing phenomenon in macroeconomic research is money illusion, whereby households tend to think in nominal terms and ignore the effects of inflation. One reason for such behaviour may be the use of rules-of-thumb in economic decision-making.^[26] See Shafir, Diamond and Tversky (1997) and Ziano et al (2021). This means that it would in fact be the nominal interest rate, and not the real interest rate, that has the greatest impact on many households' consumption decisions. The analysis becomes even more complicated if we consider that the role of real and nominal interest rates in economic decision-making is likely to differ among economic agents. For example, while many professional investors focus on real interest rates, households are likely to differ in terms of which interest rate, nominal or real, matters most. Moreover, the focus can shift depending on whether inflation is low or high.

One point of having price stability as an objective for monetary policy could be that the consequences of money illusion need not be so great. The former chairs of the Federal Reserve, Paul Volcker and Alan Greenspan, have defined price stability precisely as a condition in which inflation does not influence economic decisions, and that the public does not need to distinguish between nominal and real amounts.^[27] Greenspan expressed it as “...households and businesses need not factor expectations of changes in the average level of prices into their decisions” and Paul Volcker as “...´stability´ would imply that decision-making should be able to proceed on the basis that ´real´ and ´nominal´ values are substantially the same over the planning horizon”. See the description by Wynne (2008).

As the Riksbank pursued an expansionary monetary policy, the policy rate was negative between 2015 and 2019. This received considerable media attention, despite the fact that the real policy rate has been negative on several previous occasions in history. According to standard monetary policy analysis, the real interest rate should have had the greatest impact on demand in the economy. One reason for the attention paid to the negative policy rate may have been precisely because households and the public attach more importance to the nominal interest rate and use it as a rule-of-thumb in their economic decisions, possibly reflecting money illusion.^[28] Sveriges Riksbank (2020) and Tenreyro (2021) discuss money illusion as a possible reason for the public's scepticism about negative policy rates.

Default options with short interest-rate fixation periods

Another behavioural economic factor we mentioned earlier that can influence the effects of monetary policy is default options. In monetary policy, households' choice of interest-rate fixation periods is an important issue in terms of the impact of the policy rate on demand in the economy. The so-called cash flow channel suggests that monetary policy affects household consumption more the shorter the interest rate fixation periods are; cash flow is more affected by a given change in the policy rate.^[29] See Sveriges Riksbank (2022a) for an illustration.

In Sweden, households’ interest-rate fixation periods are short in both an international and historical perspective. But what drives households’ choices? An issue that is rarely addressed is the default option that households receive when their interest-rate fixation periods expire.^[30] For other explanatory factors, see for example Sveriges Riksbank (2023a). Until about ten years ago, the practice among banks was that households received the same fixation period again when the previous fixation period expired, unless they made an active choice by contacting the bank and requesting a different option. But reacting to this, the Swedish Consumers' Banking and Finance Bureau, among others, said that this practice risked locking many households into long fixation periods. Following a dialogue with the banks, the practice was changed to the current one, whereby households automatically receive a three-month variable mortgage rate when their fixation period expires. If the household wants a different fixation period, it must make an active choice and contact the bank. Similar to the case where households save more when they are automatically enrolled in retirement saving plans, this may have contributed to more households having variable-rate mortgages. Our point with this example is not to say that one default option is better than the other, but to highlight that default options may affect household behaviour.

Reference dependence and loss aversion in the housing market

As housing is often the largest investment a household makes, its value can have a significant impact on the ability to consume. When the Riksbank adjusts the policy rate in order to influence demand, one channel is via housing prices. For example, the value of the home affects the possibility of borrowing more money to consume, which is usually referred to as the collateral channel.^[31] See Sveriges Riksbank (2022a) for an illustration. Several studies have used prospect theory to focus on the importance of reference values and loss aversion when households make housing transactions. One hypothesis is that households use the purchase price as a reference value and are reluctant to sell their property at a loss. This could explain why falling prices are often associated with low turnover.^[32] A classical study in this area is Genesove and Mayer (2001). For more recent studies, see for example Andersen et al. (2022), Bracke and Tenreyro (2021) and Badarinza et al. (2024)

Perceived fairness affects acceptance of wage and price changes

A central component of the monetary policy analysis is the functioning of price and wage formation. In empirical macroeconomic research, an important finding is that nominal wages are sticky downwards, meaning that wage cuts are rare. But why is this the case? According to standard models in macroeconomic theory, as with the interest rate, households should care about real wages.

Behavioural economics research has two feasible explanations. First, reductions in nominal wages may naturally be seen as difficult to accept and linked to the perception of fairness. And second, rules-of-thumb and money illusion can cause households to think in nominal terms and use the nominal wage in their negotiations with their employer. Studies have shown that a nominal wage increase below the rate of inflation is much more acceptable than a wage cut in the absence of inflation, even though the real rate of increase is higher. This in turn leads employers to rarely decide to reduce nominal wages.^[33] See, for example, Kahneman et al. (1986) and Yellen (2007).

Households’ perception of fairness may also have implications for companies’ pricing behaviour. Studies have shown that it is perceived as unfair, for example, to increase the price of soft drinks when the weather is unexpectedly sunny, or to increase the price of snow shovels after a snowstorm.^[34] See, for example, Kahneman et al. (1986) and Eyster et al. (2021). This may mean that households are much more likely to accept price increases motivated by rising costs than by high demand.

Households' perception of inflation is influenced by psychological factors

Research has also shown that households, as well as companies, use rules-of-thumb when forming their inflation expectations. It turns out that an important basis for households' expectations of inflation in the economy is price developments in goods and services they buy themselves.^[35] See, for example, D'Acunto et al. (2021) and Weber et al. (2022). Some patterns that emerge from the research are that household expectations are more affected by prices that rise more than those that fall, by prices that change a lot and by prices of frequently purchased goods and services. As a result, household expectations tend to be higher than actual and expected inflation among, for example, financial market participants.

Studies have shown that high inflation is perceived as a major problem by the public.^[36] See Shiller (1997) and Stancheva (2024). This is partly due to psychological factors. One highlighted explanation is that households worry about declining purchasing power and living standards. This is consistent with a “supply-side view” of inflation, when inflation and the real economy move in different directions.^[37] See, for example, Weber et al. (2022) and Coibon et al. (2023). According to classical macroeconomic theory, higher expected inflation (all else equal) leads to lower real interest rates, which increases consumption. Although the research is not entirely conclusive, there are some indications that higher inflation expectations among households could instead lead to lower consumption, due to its association with declining living standards. Thus, a monetary policy aimed at stimulating consumption through higher inflation expectations may risk failing under certain conditions.^[38] See, for example, Weber et al. (2022).