Topic 3 - Inflation

Question 1

What is inflation?

Answer 1

Inflation is a sustained increase in the general level of prices in an economy (it is the rate at which prices for g+s rise)

Question 2

What is the ideal level of inflation?

Answer 2

2%

Question 3

Why is low inflation a major objective of eco policy?

Answer 3

Maintaining low inflation is a major objective of economic policy because of the benefits that lower inflation provides to the economy in the LT

Question 4

What is the consumer price index (CPI)?

Answer 4

CPI is a measure of the avg change over time in the prices paid by households for a fixed basket of goods and services, weighted according to their significance for the avg Aus household

Question 5

What are the 2 different ‘rates of inflation’?

Answer 5

Official/Headline rate of inflation

Underlying rate of inflation

Question 6

What is official/headline rate of inflation?

Answer 6

The headline inflation figure includes inflation a basket of goods and services. It includes everything in the CPI and is a good indicator of the cost of living

Question 7

What is underlying rate of inflation?

Answer 7

Also known as core inflation, it is a better measure that removes items in the basket of g+s which may lead to a misleading headline rate, such as seasonal price movements, items set by gov bodies, items directly influenced by RBA action. Essentially underlying inflation removes the effects of one-off or volatile price movements.

Question 8

How is underlying rate of inflation calculated?

Answer 8

Through the use of the trimmed mean and the weighted median

Question 9

What is the trimmed mean?

Answer 9

Trimmed mean; Calculates the average after excluding the 15% of items with the largest movements and the 15% of items with the smallest movement in prices from the CPI

Question 10

What is the weighted median?

Answer 10

Calculated by comparing the inflation rate of every item in the CPI and identifying the middle observation. The inflation rate of half of the items in the CPI will be greater than the weighted median inflation rate, and the inflation rate of the other half will be less than it

Question 11

Give a judgement on CPI as an indication of inflation

Answer 11

The CPI gives a good indication of the overall movement in the prices of consumer goods and reflects general changes in the cost of living.

However, CPI does not include property prices, so the changes in residential property prices in recent years have not been reflected directly in the CPI. It also doesn’t account for differences in spending patterns between individual households. The CPI doesn’t include new products as soon as they appear on the market.

Question 12

What is Real GDP?

Answer 12

GDP after being adjusted for inflation

Question 13

How is inflation rate calculated?

Answer 13

((CPI year 2 - CPI year 1) / (CPI Year 1) ) * 100

Where CPI year 2 is the value of the CPI in the current year

Where CPI Year 1 is the value of the CPi in the previous year

Question 14

What are the 4 main causes of inflation? ( +2 not in syllabus)

Answer 14

Demand Pull Inflation

Cost Push Inflation

Imported Inflation

inflationary expectations

Gov policies (not in syllabus)

Excessive increases in the money supply (not in syllabus)

Question 15

What is Demand pull inflation? How does it cause inflation?

Answer 15

Demand-pull inflation is when growing demand for goods or services meets insufficient supply, which drives prices higher.

When AD or spending exceeds the productive capacity of the economy, prices rise as output cannot expand any further in the ST forcing prices up as consumers bid against each other for limited g+s available

Question 16

What is an example of demand pull inflation?

Answer 16

This occurred in Aus in 2007-08 as full employment was reached, and demand pressures led to higher inflation

Question 17

What is cost push inflation? How does it cause inflation?

Answer 17

[Cost-push inflation is a purported type of inflation caused by increases in the cost of important goods or services where no suitable alternative is available. As businesses face higher prices for underlying inputs, they are forced to increase prices of their outputs. –> further inflation] <– kinda sus argument tho, so not sure if you should trust it

In other words, the costs of the factors of production increase –> businesses pass on the increased cost to consumers, thereby increasing the price of g+s –> higher rates of inflation through ‘cost push’

Question 18

What are major sources of cost push inflationary pressures?

Answer 18

Includes wages and the prices of raw materials such as fuels which are required in the production process. When wages increase faster than productivity growth, the cost of labour for each unit of output increases. Also includes the factors of production involved in producing the g+s

Question 19

When was cost push inflation especially evident?

Answer 19

Cost push inflation has been evident during the 2000s mining boom due to skills shortages and low UE adding to wage pressures in some areas

Question 20

What are inflationary expectations and how does it contribute to inflation?

Answer 20

Inflation expectations are the beliefs that households and firms have about future price increases. If individuals in the economy expect higher inflation in the future, they may act in a way that causes an increase in inflation, this also applies vice versa

Question 21

How does inflationary expectations actually bring about higher inflation?

Answer 21

If the prices of g+s are expected to increase in the economy, consumers will attempt to purchase products before prices increase. As consumers increase consumption, there is a higher demand-pull inflation. Similarly, if a firm expects that D for product will increase, the firm will increase prices to maximise profits, causing an inflation

If employees expect inflation to increase, they will take this into account when negotiating their wage increases. Workplace contracts are typically negotiated in advance for the next few years so an employee who expects higher inflationary pressures will ask for a higher wage rise to preserve purchasing power. Higher wage increases may be passed on by firms leading to cost push inflation

Question 22

When was inflationary expectations the main cause of inflation?

Answer 22

Especially visible during the mid 1970s and early 1980s

Question 23

What is imported inflation? How does it cause inflation?

Answer 23

This type of inflation is transferred to Aus through international transactions such as through exports and imports.

Essentially, if countries experience high levels of inflation, and then Aus imports g+s from those countries, then Aus experiences a potential imported inflation because they import higher prices –> higher prices to consumers

Question 24

What is the main cause of imported inflation? (i.e. what can cause imported inflation?)

Answer 24

Rising import prices. An increase in the price of M will increase the inflation rate in exactly the same way as an increase in the price of domestically produced goods

A depreciation of the AUD will also increase the domestic price of imports and will lead to inflation. The extent of the depreciation will lead to consumers paying higher prices for M leading to lower or higher rates of inflation (depending on er)

Question 25

When was imported inflation a main cause of inflation?

Answer 25

Imported inflation was a key driver of the surge in inflation in 2022 contributing to the peak of 7.3% in 2022

Question 26

How might government policies (out of syllabus) contribute to inflation?

Answer 26

These may directly influence the level of inflation in several ways;

By increasing indirect taxes, the gov can influence the general level of prices. For example in 2020, the gov decision to make child care free for parents during the covid lockdown reduced the headline rate of inflation to below zero

May also deregulate industries, change tariff rates, impose price controls or price monitoring and increasing charges for g+s provided by the Aus gov

Question 27

How might increases in the money supply cause inflation?

Answer 27

When the increase in the money supply outstrips the growth rate of the economy, an increased volume of money chases the same amount of g+s, and prices are likely to rise. Thus, increasing the money supply without an increase in real production, effectively leads to an increase in AD relative to supply that causes inflation (sometimes called monetary inflation)

Question 28

How might government policies cause inflation?

Answer 28

May also deregulate industries, change tariff rates, impose price controls or price monitoring and increasing charges for g+s provided by the Aus gov –> increased inflation (Overall, they have the power to influence the general level of prices)

Question 29

What are the effects of inflation? (6)

Answer 29

Wages

income distribution

Unemployment

International Competitiveness

Exchange Rate Impacts

interest Rates

Question 30

How does inflation effect wages?

Answer 30

Inflation influences nominal wage demands

During periods of higher inflation, employees will seek ↑ wage increases in order to be compensated for the erosion in the purchasing power of their nominal wages. This can result in a wage-price inflationary spiral which is difficult to break, where wage increases lead to higher prices, contributing to higher wage demands and so on.

Also, inflation can negatively impact wages, as wages are only bargained for every few years, and if a wage is just recently bargained, but inflation goes way higher than expected –> a fall in real wages (generally inflation reduces real wages)

Question 31

What is nominal wage?

Answer 31

Nominal wage refers to the pay received by employees in dollar terms for their contribution to the production process, not adjusted for inflation

Question 32

What are real wages?

Answer 32

Real wages are wages adjusted for inflation

Question 33

How does inflation effect income distribution?

Answer 33

High inflation generally is not beneficial for income distribution as lower-income earners find their incomes doesn’t rise as quickly as prices

Lower income earners may face higher interest rates on borrowings if inflation rises

High rates of inflation hurt those individuals who are on fixed incomes or whose incomes are not indexed to (rise) the rate of inflation (i.e. maybe contractors)

Higher inflation can also erode the value of existing savings so that individuals who do not have a means of protecting their savings from the impact of inflation will see their net wealth decline

Ultimately inflation worsens both income and wealth distribution

Question 34

How does inflation impact unemployment (this is one is kidna sketch, may need to double check)

Answer 34

High inflation will result in more contractionary FP and MP, resulting in slower economic growth and higher UE in the ST-MT

High levels of UE also have low inflation rates, while low UE are associated with rising inflation

On top of that high levels of inflation –> higher costs for businesses –> businesses aim to reduce costs by reducing employment –> higher levels of ue

Question 35

What is the phillips curve? What does it describe

Answer 35

The Phillips curve reveals the inverse relationship between unemployment and inflation. As unemployment is really low, inflation rate is really high, however the vice versa occurs when there is a high level of unemployment –> low levels of inflation

However, in the LT, this inverse relationship breaks down

Question 36

Explain the reason for the shape of the phillips curve

Answer 36

The belief is that when unemployment is low, there is increased disposable income, leading to increased purchases of g+s, causing a demand pull inflation. During this time, there is also high prices of wages –> increased cost push inflation. Meanwhile, during high levels of unemployment, inflation is low as consumers are less likely to demand g+s, reducing demand pull inflation

Question 37

Does Aus gov prioritise low inflation or low ue?

Answer 37

Gov has to choose which one to prioritise

Question 38

What is a stagflation?

Answer 38

An increase in inflation and u/e

This was seen in the Mid 1970s in Aus

Question 39

How does inflation affect International Competitiveness?

Answer 39

High inflation leads to increased prices for Aus exports, reducing IC and the quantity of X

Low inflation should improve Australia’s IC, making it more attractive for other countries to purchase Aus G+S, as well as making local goods more competitive with imports

Question 40

How does inflation affect Exchange Rates?

Answer 40

In ST, higher inflation results in an appreciation of the ER, as speculators expect the Reserve bank to raise interest rates in response, attracting greater financial flows

However, high inflation causes the currency to depreciate over time, which is because g+s from other countries are more attractive (as they are cheaper), leading to increased purchase of M, causing a depreciation in the e/r, this is applied vice versa

Over LT, sustained low inflation may foster greater international confidence in the economy, strengthening the value of the dollar

Question 41

How does inflation affect i/r?

Answer 41

i/r is a form of MP which is used to address inflation. During periods of high inflation, i/r will have to rise to help reduce D –> reduction in Demand pull inflation. This is the opposite during periods of low inflation, i/r will have to decrease to help increase D

Question 42

What are the negative effects of inflation on different aspects of society? (9)

Answer 42

Consumers

Workers

Savers

Producers

Exporters

Investors

Governments

Unemployment

Misallocation of resources

Question 43

What is the negative effects of inflation on consumers?

Answer 43

Consumers suffer a loss in purchasing power and real income. Unless consumer incomes keep pace with inflation, the cost of living continues to rise, reducing real income and living standards

Question 44

What are the negative effects of inflation on workers?

Answer 44

Workers or wage earners suffer a fall in real wages if their money wages do not rise by the same percentage as the increase in the rate of inflation and cost of living over time

Question 45

What are the negative effects of inflation on savers?

Answer 45

Savers will find that the real value of their savings will decline if nominal interest rates do not keep pace with inflation. Lenders will charge higher nominal interest rates to compensate for the loss in their purchasing power caused by inflation, which reduces the real returns on their loans

Question 46

What are the negative effects of inflation on producers??

Answer 46

Producers or firms react to higher costs or excess demand by putting up prices which may lead to higher menu costs as they adjust their prices. Producers may also react to higher costs by reducing their work forces to cut labour costs→↑UE

Question 47

WHat are the negative effects of inflation on exporters?

Answer 47

Exporters and import competitors may find it difficult to pass on high prod costs in the form of higher prices in markets and may suffer loss of IC in global markets

Question 48

What are the negative effects of inflation on investors?

Answer 48

Investors will find the higher costs of borrowing will make some investment projects less profitable and will reduce their demand for investment funds. Some investment decisions will be distorted if asset prices are rising faster than the prices of other G+S, leading to more speculative rather that productive investment

Question 49

What are the negative effects of inflation on governments?

Answer 49

Governments will find that the costs of providing G+S will rise, causing an increase in government expenditure. However, tax revenue will also rise as taxpayers pay more tax on higher priced consumer G+S, and wage earners are pushed into higher tax brackets (bracket creep). Govt revenue will rise due to fiscal drag (higher tax rev as higher prices and incomes), but spending will also rise due to the higher costs of providing infrastructure, welfare payments and collective G+S to public.

Question 50

WHat are the negative effects of inflation on unemployment

Answer 50

Unemployment will increase if firms substitute capital for labour because of rising wage inflation

Question 51

What are the negative effects of inflation on the misallocation of resources?

Answer 51

Inflation causes a distortion in price levels and cost structures, which consequently results in a misallocation of resources (sketch argument)

Question 52

What are the positive effects of inflation?

Answer 52

A small amount of inflation can be beneficial because it allows for adjustments in relative prices in an economy without requiring reductions in normal prices which can often be sticky (especially for wages)

The other benefit of a low positive level of inflation is that it reduces the chance of the economy experiencing a fall in prices (deflation) which can have negative consequences

Inflation leads to rising prices on assets such as shares and real estates, this can be beneficial for speculators as well as the richer individuals in society due to them having the most wealth –> exacerbation of the wealth inequality within society

Question 53

Why is deflation not a good eco outcome?

Answer 53

Deflation gives consumers an incentive to delay purchases, which can cause a fall in consumer spending and economic downturn (ultimately a self-fulfilling prophecy)

Deflation can also make borrowing money less attractive because the amount to be repaid is rising in real terms not falling