Chapter 7

Question 1

Define inflation

Answer 1

A sustained increase in the general of average level of prices

Question 2

Explain why inflation occurs

Answer 2

Prices of g+s’s will be changing on irregular basis in a modern capitalist economy like Australia’s
Prices rise and fall over certain periods of times for different reasons
Usually the price rises tend to outweigh the price falls to deliver an increase in ‘average prices’ or a sustained increase in the general or average price level over time

Question 3

What is the governments goal of inflation

Answer 3

The RBA seeks to achieve “stability of the Aus currency” meaning the RBA attempts to ensure that Aus has a stable value of Australian dollar in terms of ‘purchasing power’ over goods and services
The RBA target inflation rate is 2-3% per year on AVERAGE over the course of the economic cycle
Measured by the CPI

Question 4

Define consumer price inflation

Answer 4

Inflation as it relates to the costs of purchasing goods by consumers

Question 5

Define consumer price index

Answer 5

An indicator of consumer price inflation and measures the in the price of goods and services purchased by the average Australian household

Question 6

Why does the RBA target 2-3% growth in consumer price inflation ?

Answer 6

The Aus’t government is keen to avoid economic costs associated with high inflation – as these costs ultimately affect all Australian’s
The RBA focuses primarily on prices faced by consumers of goods + services
It targets this range of inflation because it provides the RBA with flexibility to shift it’s focus away from inflation (allowing to climb towards 3%) in an effort to achieve higher economic + employment growth
This flexibility is required for monetary policy to properly operate within it’s charter and act as a key stabilization policy of government
The range also provide a realistic target that allows for national variations in the rate of inflation over time

Question 7

Why does the gov’t not target 0% inflation ?

Answer 7

The 3 main factors preventing the RBA from targeting an inflation rate of zero:
Small amounts of inflation allow for reduction in the ‘real’ prices of some goods + services (particularly labour services) without a reduction the ‘nominal’ price (e.g. nominal wage) e.g. during a recession it may be necessary for some wages to decrease as demand for labour falls – however wages are generally ‘downward rigid’ (sticky) in nominal terms thereby causing some unemployment. This means if the economy is experiencing some inflation – the real wage can reduce without a reduction in nominal wage

Some inflation is accounted for by rising quality of goods + services – which may not be fully capture in CPI figures (CPI may be overstating extent of inflation) e.g. inflation of 4% for a year is less of a problem if the quality of goods and services increased by 4%. The ABS will not be able to accurately account for these quality improvements in their calculations

It may create other economic problems – such as growth rates that are too low, increases in unemployment and even ‘deflation’ which has a negative impact on growth and employment as consumers delay purchases in anticipation of future price reductions

Question 8

Define deflation

Answer 8

A decrease in the average price level over time - opposite of inflation

Question 9

Define nominal (or ‘real’ prices)

Answer 9

A given value adjusted for any inflationary impact

Question 10

How does inflation affect living standards

Answer 10

Erosion of Purchasing power
Loss of international competitiveness
Distorts resource allocation
Undermine effectiveness of price mechanism
Less savings (neg implications for future investment mls down

Question 11

Define purchasing power

Answer 11

The ability of cash or money or income to Aquire goods and services - this erodes overtime with inflation

Question 12

Explain how inflation affects living standards

-erosion of purchasing power

Answer 12

Erosion or purchasing power is the underlying reason why inflation has negative consequences for the economy and living standards more generally

Inflation means that the consumers of goods + services will be paying more for these products over time, which erodes the purchasing power of any given level of income or cash.
If inflation was 10% over the past year, than any given amount of cash or money today will be able to purchase 10% fewer goods + services compared to one year earlier
This significantly harms those whose income does not increase by the same rate or at the same price as inflation – leading to a reduction in their ‘real wage’
This means that purchasing power of wages falls over time and their material living standards fall – similarly those income earners on relatively fixed incomes – such as those on welfare payments will find it relatively more difficult to pay their weekly essential goods + services = reducing their standard of living

Even if income earners manage to achieve an increase in their wage to compensate for the effects of inflation – many will still loose out due to the effects of the ‘bracket creep’ (also called ‘fiscal drag’)

Question 13

Define fiscal drag

Answer 13

the process of inflation increasing nominal wages (as workers seek to affect real wages) and pushing some workers into marginal higher tax brackets – this increases the average amount of tax paid by taxpayers and boosts the real value of the federal governments tax revenue

Question 14

Explain fiscal drag (bracket creep)

Answer 14

Even if income earners manage to achieve an increase in their wage to compensate for the effects of inflation – many will still loose out due to the effects of the ‘bracket creep’ (also called ‘fiscal drag’)

Meaning as an individual receives pay rises they will eventually move into a higher tax bracket – where a higher rate of marginal taxation applies to their income this can have the effect of reducing their ‘real disposable income’

Question 15

How can inflation affect living standards

- distorting resource allocation

Answer 15

High inflation will tend to result in a less efficient allocation of the nation’s resources – this is because economic agents will continually search for ways to protect against any loss of current or future purchasing power
Investors will be seeking to ensure that there is minimal loss associated with any funds invested in markets - accordingly investment can be diverted way from productive areas that create wealth and jobs (such as investment + business capital) towards those investment opportunities that offer the best protection against inflation, such as gold, artwork and collectables, whose returns typically increase in line with (or more than) the rate of inflation. Inflation will advantage those who have sufficient resources (e.g gold) to ‘beat inflation’

Question 16

How does inflation affect living standards

- undermine effectiveness of market mechanism

Answer 16

High inflation will also undermine the effectiveness of the price or market mechanism as a means of allocating resources. This occurs because economic agents will be less certain about the real causes of price increases. Consumers will be uncertain weather price rises have occurred due to a rise in the quality of particular products and producers will be less confident about the ability of price rises to provide an accurate signal about profitability of particular products

e.g. wheat farmer who identifies a rise for alternative crops will be uncertain whether this rise could indicate greater level of profits to be made by reallocating resources to these crop or more an indication of an increase in prices ‘across the board’ due to inflation

Question 17

How can high inflation affect future living standards

- savings

Answer 17

Higher inflation will also also tend to result in consumers devoting more of their spending to current as opposed to future consumption. The erosion of purchasing power will cause more consumers to spend more now to minimize any losses associated with holding money – whose value is falling - consequently they are likely to save less of any given level of income.
This has negative implications for future living standards as there is likely to be a smaller amount of savings available for investment – with lower investment the rate of eco growth sows and MLS will fall in the future

Question 18

Explain how high inflation affects borrowing money

Answer 18

When inflation is high economic agents will find it more attractive to borrow money – because any borrowing that does take place particularly at fixed rates of interest will see the borrowers paying back less in real terms
e.g. if someone borrows $10,000 at an interest rate of 10% this would see the lender receive $1,000 in interest earnings

Question 19

How does inflation affect living standards

- loss of international competitiveness

Answer 19

Inflation that is greater than the level being experienced by Australia’s trading partners will tend to worsen our international competitiveness – this means that Australia’s ‘tradable’ sector made up of exporting firms and import competing firms will find it increasingly difficult to maintain their market share in the global economy

Inflation is likely to translate to higher export prices, encouraging foreign buyers to switch to cheaper buyers (importers) this combined effect results in lower net export income lower growth in AD or real GDP and negative affect on employment growth – overall the growth in national income levels will be smaller (or may even fall) and the ability for Aus’t to improve their MLS will be harder – this particularly applies to those individuals exposed to the traded goods sector of the Aus’t economy (exporters + businesses competing with importers)

Question 20

Explain a wage price spiral

Answer 20

High inflation tends to increase the likelihood of an economy experiencing negative effects of a wage-price spiral. This occurs when workers are concerned about the erosion of their purchasing power of their wages and demand higher wage outcomes during inflationary periods
If employers agree this demands the cost of labour increases for businesses and these costs are often passed onto the consumer in the form of higher prices
The cycle of higher prices and higher wages is then established and can be difficult to break a wage price spiral
However this was more a predominant problem when Australia has a more centralized industrial relations system characterized by greater union power

Question 21

Define a wage price spiral

Answer 21

the cycle of higher prices (or inflation) that causes an increase in nominal wages (as workers seek to protect their real wage) that in turn causes higher business costs and higher prices

Question 22

Explain inflation and interest rates

Answer 22

During periods of high inflation, nominal interest rates will start to increase as lenders seek to maintain the real rates of return on their investment. Simply lenders want to ensure that they are compensated for the effects of inflation
The change in interest rates occurs automatically in financial markets – however the RBA will be keen to reduce the interest rates across the economy
Consequently the RBA action an normal market pressures will combine to raise interest rates restrain growth in AD, reduce eco activity and decrease living standards in the short term

Question 23

How does high inflation affect other gov’t goals
Full employment
Strong and sustainable Eco growth
Quotable distinction of income

Answer 23

High inflation will have a negative effect on the governments goal to achieve ‘strong sustainable eco growth and as a consequence will make it more difficult for the government to achieve ‘full employment’

With higher rates of inflation we would expect to see a less ‘equitable distribution of income’ – this follows from having relatively higher rates of unemployment and the negative impact this has on the number of government welfare recipients. Further many low income low income groups (on fixed incomes) will experience a relatively bigger erosion of their purchasing power compared to other groups. Further low income earners will spend a greater proportion of their incomes on goods + services compared to ‘higher income earners’ – this means they have a higher ‘marginal prosperity to consume’ or a ‘lower marginal prosperity’ to save. As a result lower income earners will suffer a bigger relative decline in the purchasing power of their income, while higher income earners, will have a greater opportunity to protect the income not spent (savings) by investing in assets who prices rise in line or faster than inflation

Question 24

Define Marginal prosperity to consume

Answer 24

Measures the change in consumption that would result from one dollar increase in income (a number between 1 and 0)

Question 25

Explain how high inflation affects external stability goal

Answer 25

High inflation will also make it difficult for the government to achieve it’s goal of ‘external stability’ – the erosion of international competitiveness will decrease the demand for Australia’s net exports reduced the size of the BOP surplus or increasing the deficit (CAD) placing additional pressure on net foreign debt (NFD) – this will eventually lead to a long term deduction in the value of the Australian dollar. High inflation will cause an apperception of the exchange as high interest rates attract capital inflow. However over time Australia’s exchange rate is likely to fall as the erosion of Australia’s international competitiveness and net export demand resulting in a declining demand for the Australian currency

Question 26

Define external stability

Answer 26

When Australia is able to meet its international financial obligations that result from transactions with the rest of the world, without jeopardising Eco growth or other Eco goals requires that the CAD and the NFD of (NFE) are manageable and sustainable over time

Question 27

Define consumer price index

Answer 27

An indicator of consumer price inflation and measures the change in the price of goods and services purchased by the average Australian household

Question 28

How is inflation measured

Answer 28

Best most reliable indicator of consumer price inflation
Calculated by the ABS on a quarterly basis to determine the change in the prices of goods + services purchased by the average Australian household – it does this by collecting 100,000 goods + services that are purchased by private households in 8 Aus’t capital cities – this is called the ‘basket’ each of these goods and services is catorrised into even larger groups before being catogrised into sub-groups – weights are then attached to each groups to reflect their relative importance to the typical Australian household – this is done to ensure that any price change more accurately reflects the impact of price changes of the average household

Question 29

Why are index numbers used to calculate inflation l

Answer 29

Without the use on an index it would be too difficult for the ABS to calculate an average price of goods and services, when we have such a range of goods + services e.g. cars. Cigarettes, fridges, petrol, light globes
Once all the prices are gathered and categorized they are converted into index numbers that represent ‘the average price’ of goods + services compared to a particular ‘base period’
An index number on its own is meaningless – it needs to be compared to the base year index number from a previous period to provide the rate of growth in the CPI (or inflation)

Question 30

What is the inflation rate?

Answer 30

Price index (end) -  price index (beginning)
Inflation rate = ------------------------------------------ X 100
                           Price index (beginning)

Question 31

How do you find the annual inflation figure

Answer 31

Determined by multiplying the quarterly figure by 4

Question 32

Dei for headline rate of inflation

Answer 32

The rate of inflation as captured by price movements of all gods & service contained in the CPI

Question 33

Explain the ‘headline inflation rate’

Answer 33

The inflation rate calculated above are referred to as ‘headline’ rates on inflation – this means that they capture the price movements of all goods + services contained in the CPI
Accordingly the 2-3 % inflation rate for the year to end September refers to the ‘headline inflation rate’ or simply ‘headline inflation’

Question 34

Why does the gov’t look st underlying rather than the headline rate

Answer 34

Outlier factors
RBA set rates according to prices
Better reflection of the general change in prices

The gov’t will also seek to gain a picture of underlying inflationary pressures that exist within the economy in order to assist with a policy formulation. The ABS and the RBA each produce a set of inflation statistics that are derived from the original CPI but exclude various pieces in order to arrive at an ‘underlying rate of inflation’ this is sometimes referred to as the ‘core rate of inflation’ and will be particularly important for the RBA when deliberating on changes to monetary policy settings

The ABS calculates an inflation figure based on the normal CPI but excluding the ‘volatile items of fruit vegetables and fuel – this underlying measure is referred to as the ‘CPI all groups excluding volatile items’ and will be below the CPI headline rate when the prices of these volatile items are rising and will be higher than the headline rate, when these volatile prices are falling e.g. due to floods + cyclones it pushes the headline rate up to an annual 3.5% however these prices were excluded from underlying measures because they were one – off events and the CPI excluding volatile items rose by only 2%

Question 35

Define the CPI all groups excluding volatile items

Answer 35

An inflation measure. Are on normal CPI but excluding the ‘volatile items’ of fruit vegetables and fuel - one of the measures of ‘underlying’ inflation

Question 36

Main measures of underlying inflation

Answer 36

CPI all groups excluding volatile items
Trimmed mean
Weighted mean

Question 37

The RBA calculates 2 underlying measures than averages these to arrive at the RBAs core or underlying measure of inflation
1.
2.

Answer 37

First the RBA’s ‘trimmed mean’ involves the prices of all the CPI items but removing the top 15% of the goods + services whose prices increased the most and the bottom 15% of the goods + services whose prices increased the least – it therefore includes price changes of only 70% of the goods + services in the CPI. The ‘weighted median’ involves using the price change that sits in the middle of the range

Question 38

Define trimmed mean

Answer 38

An underlying measure of inflation calculated by measuring the price changes of all CPI items but removing the tope 15% of goods + services whose prices increased the most and the bottom 15% of goods + services whose prices decreased the least

Question 39

Define weighted mean

Answer 39

An underlying measure of inflation calculated by measuring the price changes of all CPI items and then using the price change that sits in the middle of the range

Question 40

Other measures inflation include

Answer 40

The producer price index,
the wage price index,
the terms of trade index (export price index divided by import price index)
the house price index and the pensioner and
beneficiary living cost index (PBLCI)

Question 41

Define pensioner + beneficiary living cost index

Answer 41

A price index that measure the change in the prices of goods and service most commonly purchased by pensioners

Question 42

Explain aggregate demand factors influencing inflation

Answer 42

Demand factors affecting inflation include any factor that can exert pressure on aggregate demand in the economy
Any factor that causes AD to increase will generally tend to contribute to an increase in the average price level (inflation) particularly when an economy is close to or at productive capacity
As AD increases from AD0 to AD1 the excess capacity helps to prevent prices from rising much – if at all
As AD moves from AD1 to AD2 it excretes some pressure on inflation (P0 to P1) but is relatively gentle and inflation is likely to be sitting within the RBA’s target range of 2-3%
However once AD increases from AD2 to AD3 it starts to have a significant effect on inflation (P1 to p2) because the economy is very close to it’s productive capacity – thus production cannot keep up with demand exerting upward pressure on prices
In order to analysis how each demand factor affects inflation one needs to demonstrate how the factor impacts on AD and the analysis from this point is the same (AD chapter 5)

Question 43

Explain aggregate supply in influencing inflation

Answer 43

Supply factors affecting inflation include any factors that exert pressure on aggregate prices in the economy via changes in the costs of production or restrictions to aggregate supply levels
Alternatively it represents inflation that has been caused by ‘supply side’ pressures in the economy (this is demonstrated in figure 7.4 – where less favourable AS condtions (e.g. drought) will move the AS curve from AS1 to AS2 – as production costs across the economy rise, (the increase in price level from P1 to P2)

"ASSUMING WE ARE AT OR NEAR PRODUCTIVE CAPACITY"

Question 44

Define inflationary expectations

Answer 44

The expectation of future price increase by economic agents

Question 45

Explain inflationary expectations

- wage spirals

Answer 45

Expectations of future price increases can actually cause inflation – as workers, suppliers, producers and Gov’t expect the price to rise and seek to maintain their real purchasing power by demanding higher nominal incomes, such as wages – even before the price rises have actually occurred theses actions accentuate inflation
Can trigger a ‘wage price spiral’ which can be difficult for the gov’t to reverse

Real disposable income – growth in disposable income reflects stronger AD growth and eco activity – this increased demand inflationary pressures