Inflation

Question 1

Measuring Inflation:

Answer 1

Inflation rate: The percentage increase in the price level from one period to the next.

 E.g. if the price level increases from 200 from one year to 208 the next, the inflation rate = 100*(208-200)/200 = 4%.

 To measure inflation, we need to first measure the price level.

Question 2

Price level =

Question 3

Consumer Price Index =

Answer 3

• It is by far the most commonly used price index for measuring inflation.
• Also referred to as the cost-of-living index.
• The Reserve Bank of Australia (RBA) has an inflation target of maintaining consumer price inflation between 2 and 3%.
• It measures how much the typical family of 4 in capital cities needs to spend on a representative basket of G&S in a particular year relative to the expenditure on the same basket in the base year.

Question 4

Consumer Price Index: ABC market basket calculation

Answer 4

• The ABS surveys households on their spending habits to construct a representative market basket of G&S for the typical family of 4.
• Each quarter the ABS gather information on the prices of those G&S from a large number of goods sellers and service providers in the 8 capital cities.
• Items that are consumed more are weighted more heavily.

Question 5

Summary: 3 steps to calculate Inflation:

Answer 5

Question 6

The Base Year:

Answer 6

• Any year can be used as the base year.
• It does not have to be the first year of the data set.
• Change the base year typically will change CPI figures.
• The inflation figures, however, should remain the same regardless which year is chosen as the base year

Question 7

Adjusting for the Effects of Inflation:

Answer 7

• The purchasing power of the dollar falls over time as prices rise.
• Price indexes, such as the CPI, allow us to adjust for the effects of inflation so we can compare dollar values across different time periods.

Question 8

Nominal vs Real variables:

Answer 8

• Nominal variables: Economic variables not adjusted for inflation.
• Real variables: Economic variables adjusted for inflation.
• Real wage = (nominal wage/CPI)*100
• Real GDP = (nominal GDP/GDP deflator)*100

Question 9

Nominal vs Real Interest Rates Formulas

Answer 9

Approximated equation : r » i - π

• r = real interest rate
• i = nominal interest rate
• π = inflation rate
• In the exact equation, r, i and π are expressed in decimal points (e.g. 0.03 instead of 3%)
• In the approximated equation, r, i and π can be expressed in either decimal points or %.

Question 10

Nominal vs Real Interest Rate:

Answer 10

• Real interest rate represents the true cost to borrowers, and thus the true (before tax) return to lenders.
• If the actual inflation differs from the expected inflation, the true cost and return will be different from the expected cost and return.

Question 11

Inflation Implications:

Answer 11

• Unexpectedly higher or lower inflation will lead to a redistribution of wealth.
• High inflation volatility and uncertainty could be harmful to saving and investment, and subsequently long-term economic growth.
• Governments with large public debts will have incentives to raise inflation above the expected level to reduce their real cost of borrowing.

Question 12

Deflation and Disinflation:

Answer 12

• Deflation: a decrease in the price level in the economy, i.e. negative inflation (e.g. -2%).
• Disinflation: a reduction of the inflation rate, e.g. from 4% to 3%.

Question 13

What Causes Inflation?

Answer 13

• In a nut shell, inflation is caused by too much money chasing too few G&S.
• That is, inflation can be caused by too much demand (demand-pull inflation) or too little supply (cost-push inflation).

Question 14

Demand Pull Inflation:

Answer 14

• Demand pull inflation is caused by an increase in the aggregate demand for G&S (i.e. a positive demand shock).
• But production levels are unable to meet this demand immediately, e.g. when the economy is at full employment.
• So the excess demand pulls up the price level.
• It is characterized by higher employment and output.

Question 15

Examples of Positive Demand Shocks:

Answer 15

• Expansionary monetary policy
  
  • Increase in monetary supply
  • Decrease in the cash rate
• Expansionary fiscal policy
  
  • Increase in government expenditure
  • Decrease in taxes
• Increase in consumer confidence and thus autonomous spending
• Increase in business confidence and thus autonomous investment
• Increase in export demand from overseas

Question 16

Cost Push Inflation:

Answer 16

• Cost push inflation is caused by a decrease in the aggregate supply of G&S (i.e. a negative supply shock).
• It also occurs when there is an increase in costs of production not resulting from an increase in aggregate demand.
• It is characterized by lower employment and output.

Question 17

Examples of Negative Supply Shocks

Answer 17

• Natural disasters (e.g. flood, drought) and war.
• Increase in import prices (e.g. higher petroleum/food prices for net energy/food importing countries).
• Increase in wages that exceed productivity growth (e.g. if the labour union is too powerful).
• Increase in electricity price (e.g. if there is less competition in the energy industry).

Question 18

Price-Wage Spiral

Answer 18

• Demand-pull inflation will raise the price level and thus lower the real wages for workers.
• If workers bargain for higher nominal wages to compensate for inflation, this will lead to higher production costs and therefore cost-push inflation