Chapter 7 - The goal of low inflation Flashcards
What is the definition of inflation?
Inflation refers to a sustained increase in the general or average price level over time.
What is the RBA’s low inflation goal?
The RBA’s specific inflation target is to contain the increase in consumer price inflation to 2-3% on average over the course of the economic cycle, where consumer price inflation represents the rate of inflation as it applies to Australian consumers.
Why does the RBA target 2-3% growth in consumer price inflation?
The RBA targets 2-3% growth in consumer price inflation as they are keen to avoid the economic costs associated with high inflation.
Why doesn’t the RBA target an inflation rate of zero?
(3 main factors)
- Small amounts of inflation allow for reductions in real prices of goods and services (e.g. labour) without a reduction in nominal prices (e.g. wages)
- Some inflation is really accounted for by rising quality of goods and services, which may not be fully captured in CPI figures.
- Zero inflation may create other economic problems like low growth rates and increases in unemployment or even deflation, which has a negative impact on growth and employment as consumers delay purchases in anticipation of future price reductions
What are the definitions of deflation and disinflation?
- Deflation: general decline in price levels over time
- Disinflation: a decrease in the rate of inflation
Inflation and living standards
All countries seek to control inflation rates because it is recognised that high inflation has real negative consequences for their economies, including a reduction in the rates of economic growth, less than full employment, declining incomes and a deterioration in material living standards.
- The erosion of purchasing power
- Distorting the allocation of resources
- Loss in international competitiveness
- Declining business confidence
- A wage-price spiral
- Inflation and interest rates
- Inflation and goverment goals
Inflation and living standards: Erosion of purchasing power
Erosion of purchasing power: inflation means consumers are paying more for goods and services, thus eroding purchasing power of any given income (decline in real value of money). This particularly harms low-income workers on relatively fixed incomes.
- Bracket Creep (fiscal drag): individual income rises, thus individual will eventually move to a higher tax bracket, even though the real value of their money has not changed (thus, erosion of purchasing power)
Inflation and living standards: Distorting the allocation of resources
Distorting the allocation of resources: less efficient allocation of resources as economic agents search for ways to protect against loss of purchasing power, thus investment is diverted away from productive areas. Also high inflation will undermine the effectiveness of the price or market mechanism as a means of allocating resources.
Inflation and living standards: Loss of international competitiveness
Loss of international competitiveness: tradeable sector (exporting and import-competing firms) will find it difficult to maintain a global market share due to higher prices.
Inflation and living standards: Damaging business confidence
Damaging business confidence: High inflation tends to damage business confidence
Inflation and living standards: Wage-Price Spiral
Wage Price Spiral: higher prices force employees to seek higher wages and thus increase business costs which is passed on in the form of even higher prices by the business.
Inflation and living standards: Interest Rates
Inflation and interest rates: high inflation will cause nominal interest rates to increase as lenders seek to maintain real rates of return on their investment
Inflation and living standards: Inflation and government goals
Inflation and government goals: high rates of inflation causes a less equitable distribution of income and low-income earners to spend more as a greater proportion of their income is dedicated to goods and services. This means that they will have a higher marginal propensity to consume.
What is the consumer price index?
The Consumer Price Index (CPI) is the best and most reliable indicator of consumer price inflation as it is calculated by the ABS on a quarterly basis to determine the change in goods and services purchased by the average Australian household.
How is the inflation rate calculated?
Inflation Rate = Price Index (end) - Price Index (beginning) / Price Index (beggining) X 100
Aggregate demand factors influencing inflation
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 tend to contribute to an increase in the average price level (inflation), particularly when an economy is close to (or at) productive capacity.
- Interest Rates
- Inflationary Expectations
- Real Disposable Income
- Government Assistance and Regulation
- The Exchange Rate
- Overseas growth rates
- Consumer confidence
Aggregate supply factors influencing inflation
Supply factors affecting inflation, include any factor that can exert pressure on aggregate prices in the economy via changes in the costs of production or restrictions to aggregate supply levels.
- Interest Rates
- Taxation Rates
- Government assistance and regulation
- Exchange rate
- Overseas growth rates
- Business Confidence
- Terms of Trade
- Productivity
- Labour Costs
- Participation Rates
- Industrial disputation
- Climatic or geopolitical
