Inflation Flashcards
Define inflation
A sustained increase in the general level of prices in an economy over time
Define deflation
A sustained decrease in the general level of prices in an economy over time
Define disinflation
A decrease in the rate of inflation
What is the most widely used measure of inflation in Australia?
The Consumer Price Index (CPI)
What does the CPI summarise?
The movement in prices of a basket of goods and services weighted according to their significance for the average household
ie - general changes in the cost of living
How is the annual inflation rate calculated?
The percentage change in CPI over the year
(CPI Current Year - CPI Previous Year) / CPI Previous Year
What item of household expenditure does the CPI exclude?
Property Prices
Define headline inflation
The official rate of inflation as calculated by the CPI
Define underlying inflation
The rate of inflation that removes one-off seasonal or volatile price movements
What are the two measures of underlying inflation?
Trimmed Mean
Weighted Mean
How is the trimmed mean calculated?
Inflation is determined by calculating the average inflation rate after excluding the 15% of items with the largest and smallest price increases
How is the weighted mean calculated?
Inflation is calculated by comparing the inflation rate of every item in the CPI and identifying the middle observation
How does the RBA calculated underlying inflation?
It adds the trimmed and weighted means, then divides them by two
What does the PPI measure?
The Producer Price Index measures the average changes in prices received by domestic producers for their output
What are some recent trends to do with Australia’s inflation rate?
Since the early 1990s, Australia has sustained low inflation after experiencing relatively high inflation in the 1970s and 80s (9% headline in 1990)
Inflation fell in the 1990s due to structural changes and microeconomic reform that increased productivity growth
A key factor behind this success was the introduction of inflation targeting of between 2-3% in 1993
Whenever inflationary pressures have emerged (1999, 2007) the RBA has increased interest rates to slow down the growth in demand and curb inflation increases
Likewise, headline inflation has been below the RBA target for a number of years, which has played a key role in the RBA decision to reduce interest rates to record low
Between 1996-2020, headline and underlying inflation averaged 2.4% and 2.6% respectively
The COVID-19 recession began with the largest quarterly fall in the CPI since 1931 and the first annual decline in inflation since the 1960s
What are the four main causes of inflation?
Demand-Pull
Cost-Push
Imported Inflation
Inflationary Expectations
Define demand-pull inflation
Occurs when aggregate demand or spending is growing while the economy is nearing its supply capacity, so that higher demand leads to higher prices rather than more output
Define cost-push inflation
Occurs when there is an increase in production costs (such as oil price increases or wage increases) that producers pass on in the form of higher prices
Define inflationary expectations
If consumers expect the price of products in an economy to increase, they will bring forward their purchases, resulting in demand-pull inflation
If employees expect inflation to increase, they will demand higher wages to preserve their purchasing power and pass on costs to firms, leading to cost-push inflation
Define imported inflation
An increase in the price of imported goods or a depreciation of the Australian dollar will increase the inflation rate, as importers will raise prices in order to cover their costs
A 2015 RBA research paper found that imported inflation now makes a much larger share of headline inflation, reflecting Australia’s increased links with other economies
How can government policies impact inflation?
In 2020, the government’s decision to make childcare free during the COVID-19 lockdown helped reduce headline inflation below zero
Other methods include indirect taxes, deregulating industry, imposing price controls and changing tariffs
How can excessive increases in the money supply impact inflation?
When the increase in the money supply outstrips the growth rate of the economy, an increased volume of money chases the same amount of products, resulting in price increases
How does inflation impact economic growth?
Inflation is one of the major constraints on economic growth as higher interest rates designed to curtail inflation will also dampen aggregate demand
It can also lead to the misallocation of resources, with business investment decreasing due to price uncertainty
Sustained lower inflation allows moderate economic growth to be maintained without it becoming necessary to curtail growth through higher interest rates
How does inflation impact wages?
Inflation will lead to employees demanding higher nominal wages to compensate for the real decline
Increased inflation can lead to a ‘wage-price spiral’ where wage increases lead to higher prices, etc
How does inflation impact income distribution?
Those who gain:
- Borrowers on Fixed Repayment Plans
- Owners of Land & Physical Assets
Those who lose:
- Individuals on Fixed Incomes
- Savers
- Borrowers on Variable Rates
- Exporters
How does inflation impact unemployment?
Higher inflation will usually result in more contractionary macroeconomic policies, resulting in slower economic growth and higher unemployment in the short to medium term
What are some of the other negative impacts of inflation?
Reduces Australia’s international competitiveness
In the short term, higher inflation may result in an appreciation due to interest rate increases
- However, high inflation generally causes the currency to depreciate as exports become increasingly expensive
Higher inflation usually leads to higher interest rates
Governments will find that the costs of providing goods and services will rise during inflationary periods causing an expansion in government expenditure
What are some of the limited benefits of inflation?
A small amount of inflation allows for adjustments in relative prices in an economy to occur other than wages
It reduces the likelihood of deflation - this is good because deflation can lead to a fall in consumer spending and economic downturn
What is the main policy used to reduce inflation?
Monetary policy is the major tool used to reduce inflation - a key factor in Australia’s low inflation rates has been pre-emptive monetary policy by the RBA
Fiscal policy can be used to increase revenue and reduce spending, lowering aggregate demand
In terms of microeconomic policy, reduced protection has increased competition in the market, making it more difficult for domestic producers to raise their prices
