Nominal or Real? The Impact of Regional Price Levels on Satisfaction with Life

According to economic theory, real income, i.e., nominal income
adjusted for purchasing power, should be the relevant source of
life satisfaction. Previous work, however, has only studied the
impact of inflation adjusted nominal income and not taken into
account regional differences in purchasing power. Therefore, we use
a novel data set to study how regional price levels affect
satisfaction with life. The data set comprises about 7 million data
points that are used to construct a price level for each of the 428
administrative districts in Germany. We estimate pooled OLS and
ordered probit models that include a comprehensive set of
individual level, time-varying and time-invariant control variables
as well as control variables that capture district heterogeneity
other than the price level. Our results show that higher price
levels significantly reduce life satisfaction. Furthermore, we find
that a higher price level tends to induce a larger loss in life
satisfaction than a corresponding decrease in nominal income. A
formal test of neutrality of money, however, does not reject
neutrality of money. Our results provide an argument in favor of
regional indexation of government transfer payments such as social
welfare benefits.