The authors cite psychological studies that have found that decisionmakers edit the information available to them, ignoring much that is potentially relevant in order to concentrate on the few factors that matter most. Similarly, studies on the psychology of perception show that an event or stimulus must pass a threshold before it is even perceived, let alone used. In addition, from interviews with compensation professionals, the authors infer that wage setters do not behave as most economic models assume. Rather than choosing a real wage target and then adjusting it fully for expected inflation, they mix information about inflation with a variety of other information relevant to wage setting. And from interviews of the lay public by Robert Shiller and questionnaire studies by Eldar Shafir, Peter Diamond, and Amos Tversky, they find telling evidence about how people perceive and react to inflation.
Employees systematically underestimate the tendency of inflation to boost their own nominal wages.
They are pleased by their wage increases while not fully recognizing the corresponding rise in prices. Drawing on these insights, the authors construct a model in which firms pay an efficiency wage and workers respond according to their view of job and wage opportunities outside the firm. The crucial issue is how wage-setting behavior varies with the inflation rate. At any given time, some firms and their workers are fully rational, their wage setting fully incorporating expected inflation. At the same time, other firms or their workers are near rational and their wage setting responds fully to current conditions in their labor market, but less than fully or not at all to expected inflation.