Inflation

Question 1

Define inflation

Answer 1

A sustained increase in the general level of prices in an economy over time

Question 2

Define deflation

Answer 2

A sustained decrease in the general level of prices in an economy over time

Question 3

Define disinflation

Answer 3

A decrease in the rate of inflation

Question 4

What is the most widely used measure of inflation in Australia?

Answer 4

The Consumer Price Index (CPI)

Question 5

What does the CPI summarise?

Answer 5

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

Question 6

How is the annual inflation rate calculated?

Answer 6

The percentage change in CPI over the year

(CPI Current Year - CPI Previous Year) / CPI Previous Year

Question 7

What item of household expenditure does the CPI exclude?

Answer 7

Property Prices

Question 8

Define headline inflation

Answer 8

The official rate of inflation as calculated by the CPI

Question 9

Define underlying inflation

Answer 9

The rate of inflation that removes one-off seasonal or volatile price movements

Question 10

What are the two measures of underlying inflation?

Answer 10

Trimmed Mean

Weighted Mean

Question 11

How is the trimmed mean calculated?

Answer 11

Inflation is determined by calculating the average inflation rate after excluding the 15% of items with the largest and smallest price increases

Question 12

How is the weighted mean calculated?

Answer 12

Inflation is calculated by comparing the inflation rate of every item in the CPI and identifying the middle observation

Question 13

How does the RBA calculated underlying inflation?

Answer 13

It adds the trimmed and weighted means, then divides them by two

Question 14

What does the PPI measure?

Answer 14

The Producer Price Index measures the average changes in prices received by domestic producers for their output

Question 15

What are some recent trends to do with Australia’s inflation rate?

Answer 15

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

Question 16

What are the four main causes of inflation?

Answer 16

Demand-Pull

Cost-Push

Imported Inflation

Inflationary Expectations

Question 17

Define demand-pull inflation

Answer 17

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

Question 18

Define cost-push inflation

Answer 18

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

Question 19

Define inflationary expectations

Answer 19

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

Question 20

Define imported inflation

Answer 20

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

Question 21

How can government policies impact inflation?

Answer 21

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

Question 22

How can excessive increases in the money supply impact inflation?

Answer 22

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

Question 23

How does inflation impact economic growth?

Answer 23

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

Question 24

How does inflation impact wages?

Answer 24

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

Question 25

How does inflation impact income distribution?

Answer 25

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

Question 26

How does inflation impact unemployment?

Answer 26

Higher inflation will usually result in more contractionary macroeconomic policies, resulting in slower economic growth and higher unemployment in the short to medium term

Question 27

What are some of the other negative impacts of inflation?

Answer 27

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

Question 28

What are some of the limited benefits of inflation?

Answer 28

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

Question 29

What is the main policy used to reduce inflation?

Answer 29

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