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In late 2022, many supply chain disruptions had been resolved, yet annual U.S. inflation still ran close to 7 percent. With costs normalizing—yet prices remaining high—businesses’ profits were rising. Shareholders were eager to understand whether high prices and profits would continue. For example, the CEO of McDonald’s was asked during an earnings call about possible consumer pushback on high menu pricing. He reported that the chain’s “resilient” customers were willing to accept its “strategic price increases.” Parallel decisions by thousands of other firms shaped the overall inflation experience of American households.
Why did inflation remain high despite supply constraints moderating? And why did inflation appear more persistent in lower-priced market segments (a post-pandemic phenomenon labeled “cheapflation”)? Minneapolis Fed economists Simon Mongey and Michael Waugh believe the answers lie in how sensitive different customers are to prices when deciding which goods to buy—and which households become less price sensitive with more money in their pockets.
In a new paper, Mongey and Waugh update a workhorse macroeconomic model to reflect the discrete choices made by consumers of varying incomes (Minneapolis Fed Staff Report 664, “Pricing Inequality”). The economists’ model links the decrease and then increase in price sensitivity of customers over the pandemic period to the enormous increase and then decrease in household liquidity.
By early 2021—following three rounds of direct fiscal stimulus payments, expanded unemployment benefits, and a general lack of spending opportunities—American households had real cash balances more than 50 percent higher than pre-pandemic levels. This increase in liquidity was especially large for lower-income households. Under the economists’ model, households given additional savings become less discerning when choosing between differently priced options. This presents an opportunity for firms to mark up prices over marginal cost further than otherwise would be possible, keeping prices higher.
The incidence of inflation across firms and households depends heavily on the different changes in choosiness among rich and poor households. Poorer households place a higher value on a dollar of additional savings. While extra cash on hand has little effect on high-income households’ shopping, low-income households become much less price sensitive. Low- and middle-priced firms, such as McDonald’s, respond to this increased “resilience” in their core customer base. These lower-priced firms can increase prices more while experiencing a relatively small decline in customers (the “pricing inequality” of the staff report’s title).
Mongey and Waugh calibrate their model to detailed microeconomic data on household consumption and firms’ pricing behavior. To assess the effect of excess savings on overall inflation, they conduct a counterfactual exercise mimicking the fiscal stimulus payments during the pandemic: a one-time transfer to households, financed by government debt. In their model, household savings increase proportionately much more for low-income households (Figure 1, Panel A).
Source: Mongey and Waugh, “Pricing Inequality,” January 2025.
The consequent decline in household price sensitivity leads firms to increase their prices above marginal cost. While costs increase somewhat in addition to this markup, Mongey and Waugh find that more than three-quarters of the increase in prices is due to the larger markup, leading to a substantial boost in profits that lasts up to five years after the initial stimulus (Figure 1, Panel B).
They find that a transfer of 1 percent of GDP to households increases the markup of prices over marginal costs by 0.3 percentage points. Translating this to actual post-pandemic figures: The San Francisco Fed estimates that excess household savings peaked at 7.5 percent of GDP in late 2021. In Mongey and Waugh’s model, this would equate to a 2.25 percentage point increase in prices—a significant effect layered on top of other inflation from supply-driven factors.
The model put forth by Mongey and Waugh presents a new extension of existing “heterogeneous agent” macroeconomic models. The authors’ starting point is the workhorse “incomplete markets” model—pioneered by Minneapolis Fed economists, including Tom Sargent and Ed Prescott, and often used to study economic policies where household heterogeneity is key. To this model, Mongey and Waugh add an industrial organization model of “discrete choice.” This addition allows them to capture different spending patterns of poor and rich consumers and to match recent empirical evidence on the different price sensitivities of poor and rich consumers. Specifically, they leverage a 2023 paper in The Review of Economic Studies that documents how shoppers responded to the sudden change in prices after the 2015 appreciation of the Swiss franc. In this rare natural experiment, lower-income shoppers were more price sensitive and switched more aggressively to cheaper goods.
Mongey and Waugh’s approach provides a theoretical explanation for many empirical relationships documented in top economics journals in the last decade. These relationships include: (1) Low-income households tend to buy from smaller, lower-priced firms; (2) firms grow large not by selling more goods per customer, but by selling to more customers; (3) firms have a high sales volume not because they sell at cheaper prices, but because they sell higher-quality goods at higher prices; and (4) larger firms are more profitable.
A novel finding of Mongey and Waugh is that higher profits at larger firms are not necessarily due to market power (being a “big player” in a market and therefore able to charge a higher price). While market power has been a primary story for markup differences across firms in the macroeconomics literature, Mongey and Waugh instead find that the power to mark up prices comes from high-quality firms’ ability to sell to higher-income households, who—consistent with the evidence from Switzerland—are less price sensitive.
The exercises in “Pricing Inequality” sound a cautionary note for common policies used to stabilize the economy in a recession. Direct payments targeted at low-income households are regarded by many as effective economic stimulus, under the presumption that low-income households spend a lot of the checks. While low-income households may indeed have a higher “marginal propensity to consume” any money they receive, Mongey and Waugh highlight that those households’ sensitivity to prices also drops the most following such payments. The subsequent shifts in shopping behavior can spark higher inflation—especially on goods consumed by those households.
By connecting household liquidity, price sensitivity, and the pricing behavior of firms, the model potentially offers a lab for researchers studying many economic policies. “For example, are the positive effects of unemployment insurance or universal basic income partially undone by reduction in households’ price sensitivity and firms’ price responses?” Mongey and Waugh write. “How do the distributional impacts of monetary policy shape markup responses of firms?” In separate work by Waugh, these insights on heterogeneous household price sensitivity reveal the starkly uneven benefits of trade. And as a microeconomic tool, a better understanding of price sensitivity at different income levels holds implications for marketing and product design.
Read the Minneapolis Fed staff report: “Pricing Inequality”
Jeff Horwich is the senior economics writer for the Minneapolis Fed. He has been an economic journalist with public radio, commissioned examiner for the Consumer Financial Protection Bureau, and director of policy and communications for the Minneapolis Public Housing Authority. He received his master’s degree in applied economics from the University of Minnesota.
