Inflation

Question 1

Define inflation

Answer 1

Refers to a sustained increase in the general level of prices in an economy

Question 2

How is the inflation rate calculated?

Answer 2

CPI(y2) - CPI(y1)
———————- * 100
CPI (y1)

Question 3

Why does the RBA use underlying CPI measures rather than headline CPI when inflation targeting?

Answer 3

The RBA uses underlying CPI measures (‘core’ inflation) because it removes items that may lead to a misleading headline rate - more accurate

Question 4

What are the causes of inflation?

Answer 4

DIG CIM

• Demand-pull (when AD exceeds productive capacity of the economy (AS))
• Cost-push (caused by increase in the COP)
• Inflationary expectations
• Imported inflation (transferred to Aus through international transactions)
• Government policies (expansionary macro policies)
• Money supply (increases in MS that outstrip the growth rate - inflation)

Question 5

What effect does inflation have on the economy?

Answer 5

Acronym: WIII EUE

• Economic growth
• Wages
• Incomes Distribution
• Unemployment
• International Competitiveness
• ER Impacts
• Interest rates

Question 6

How does low/high inflation impact economic growth?

Answer 6

LOW:
- (+) removes distortions to investments and savings decisions caused by higher inflation > higher incentive to invest in LT assets
HIGH:
- Consumers spend more > PP of their money is reduced over time - assets are rising in value and savings will fall

Question 7

How does low/high inflation impact wages?

Answer 7

LOW:
- helped reduce annual wage growth to just over 2%
HIGH:
- employees will seek larger wage increases > wage-price inflationary spiral - difficult to break - increases in wages lead to higher prices etc.

Question 8

How does high inflation impact income distribution?

Answer 8

Negative impact > low Y earners – Ys don’t rises as quickly as prices > may also face higher IR on their borrowings if inflation rises

Question 9

How does low/high inflation impact unemployment?

Answer 9

LOW:
- high UE = low inflation - govt may have to choose between low inflation or low UE
HIGH:
- More contractionary MP > slower eco growth > higher UE in ST-MT

Question 10

How does low/high inflation impact international competitiveness?

Answer 10

LOW:
- Improves IC > Aus X become more attractive and makes local products more competitive > domestic substitutes replace M > improves trade deficit
HIGH:
- Increases price of X > worsens IC > lower quantity of X > consumers switch to M substitutes > worsens trade deficit

Question 11

How does low/high inflation impact the exchange rate?

Answer 11

LOW:
- in LT fosters greater international confidence > strengthens AUD value
HIGH:
- in ST results in appreciation of ER > speculators anticipate that RBA will raise IR in response > attracts greater financial flows
- generally causes currency to depreciate over time

Question 12

How does low/high inflation impact interest rates?

Answer 12

LOW:
- reduction in nominal IR (which is based on the real rate of return + inflation)
HIGH:
- higher IR as central banks try to reduce demand pressures to avoid negative consequences of higher inflation