Inflation: Basics Flashcards
What is inflation?
A rise in the general level of prices in an economy
How is inflation calculated?
[(CPI in Year 2 - CPI in Year 1) / CPI in Year 1] x 100
What is the CPI?
An index of changes in the price of a basket of goods and services, weighted by the proportion of household spending on each item
What is the difference between headline and underlying inflation?
Headline measures prices changes in all goods and services, whereas underlying removes the most volatile items (e.g. petrol, fruit)
How do you calculate real GDP?
(Nominal GDP / CPI) x 100
What are 4 causes of inflation?
- Demand
- Cost
- Imported
- Inflationary expectations
What is demand inflation?
An increase in aggregate demand causes customers to bid up the prices of scarce goods and services
What is cost inflation?
An increase in production costs causes firms to raise prices of goods and services
What is imported inflation?
An increase in prices of imported products leads to higher prices in the domestic economy
Why do inflationary expectations cause inflation?
If individuals expect high inflation, they will demand higher wage rises. These higher wages will increase firms’ costs, causing the expected inflation to actually occur.
Also, if firms expect inflation, they will raise prices ahead of the expected rise in input costs. Raising prices will cause the expected inflation to occur.
What are 5 costs of inflation?
- Reduced growth
- Reduced purchasing power
- Worse inequality
- Worse international competitiveness
- Higher interest rates
Why does inflation slow economic growth?
A number of reasons:
1) It reduces international competitiveness
2) Firms are less likely to spend on investment (e.g. expansion), because it is unclear if price rises are because their product is popular or just because of general inflation
3) Wage negotiations focus on ensuring wages keep up with inflation, rather than on rewarding improvements in labour productivity
What are 3 benefits of inflation?
1) Avoids risk of deflation
2) Potential for downward wage adjustments
3) Bracket creep
What is the RBA’s inflation target?
2-3% on average over the course of the business cycle
When did the RBA start inflation targeting?
1993
What have been the main trends in Australia’s inflation rate?
In general, has averaged between 2-3% since 1993.
Was below 2% for 6 years prior to the pandemic.
Fell significantly during the pandemic.
Spiked in 2022/3.
Has fallen in 2024
Why did inflation fall in the pandemic?
1) Low consumption and private investment
2) Child care subsidy temporarily covered the full cost of child care
Why didn’t inflation fall further in the pandemic?
1) Disruptions to shipping and labour increased firms’ costs
2) 2020 bushfires also increased price of food and timber
3) Expansionary macro policy, including unconventional monetary
Why has inflation spiked so much in 2022?
1) Continued expansionary macro policies
2) Global supply chain disruptions (increased demand for goods and fewer plane flying means shipping costs up by over 700%)
3) Labour shortages
4) Russia sanctions increasing oil prices
What are the 3 policies used to control inflation?
1) Monetary policy
2) Fiscal policy
3) Microeconomic reform
What is the main policy used to control inflation?
Monetary policy
If inflation is high, should the RBA raise or lower the cash rate?
Raise it
If inflation is low, should the RBA raise or lower the cash rate?
Lower it
If inflation is high, should the government tax more or less?
Tax more
If inflation is low, should the government tax more or less?
Tax less
If inflation is high, should the government spend more or less?
Spend less
If inflation is low, should the government spend more or less?
Spend more
How does microeconomic reform help to control inflation?
By improving competition and efficiency, firms will find ways to lower prices
