Week 5 Flashcards
what is price level, inflation and inflation rate
§Price level: A measure of the average prices of goods and services in the economy.
§Inflation: The sustained increase in the general level of prices in the economy.
§Inflation rate: The percentage increase in the general price level in the economy from one year to the next.
Consumer price index (CPI):
§The CPI is the most widely used measure of inflation.
§: A measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities.
what the ABS’s role in terms of CPI
§The Australian Bureau of Statistics (ABS) surveys households on their spending habits.
–The goods and services typically purchased by households is the ‘market basket’.
–The prices of goods and services in the market basket are given a weight according to their fraction of a ‘typical’ family budget.
The CPI measures
measures the rate of change in the prices of the goods and services in the market basket
Find the 2016 inflation rate
Four sources of bias in the CPI may lead to it overstating the inflation rate
–Substitution bias
–Increase in quality bias
–New product bias
–Outlet bias
measuring inflation
The producer price index (PPI):
§: An average of the prices received by producers of goods and services at all stages of the production process.
§Like the CPI, the PPI tracks the prices of a market basket of goods.
calculate the inflation rate
CPI = expenditures in current yr/ expenditures in base yr x 100
CPI in 2011 = 314/314 x 100 = 100
CPI in 2015= 360/314 x 100 = 114.65
Inflation rate = CPI in current yr- CPI in base yr/ 100 x 100 = 114.65-100/100 x 100=
what happens to purchasing power when prices rise
The purchasing power of the dollar falls
Price indexes, such as the CPI, enable
§adjustments to be made for the effects of inflation, so dollar values can be compared over time.
The 2013 purchasing power equivalent of a $20 000 salary in 1980 can be found
Nominal interest rate and real interest rate
§The stated interest rate on a loan.
§Real interest rate: The nominal interest rate minus the inflation rate.
If the inflation rate is higher than expected
borrowers may gain and lenders receive a lower real interest rate (on a fixed interest rate loan).
The real interest rate provides a better measure of
§the true cost of borrowing and the true return to lending than does the nominal interest rate.
It is possible for the nominal interest rate to be less than the real interest rate when
there’s deflation - rare in australia
When the inflation rate is high, the gap between nominal and real interest rates
often becomes large
Does inflation impose costs on the economy?
Nominal incomes generally rise with inflation
§For the ‘average’ person, nominal wages increase with inflation.
Inflation and the distribution of income
what happens to people on fixed incomes
§People on fixed incomes are likely to experience reduced purchasing power due to inflation.
INflation and distribution of income
what does the extent of distribution depend on
§degree to which inflation is anticipated or unanticipated.
does inflation pose costs on the economy
Problems with anticipated inflation
§Income redistribution, as some people’s income will fall behind anticipated inflation.
§For those holding wealth in paper money.
does inflation pose costs on the economy
Problems with anticipated inflation
menu costs?
Menu costs: The costs to firms of changing prices
does inflation pose costs on the economy
Problems with anticipated inflation
taxes?
Increases taxes paid by those who own income generating assets, such as bonds, shares and deposits, and also increases personal income taxes paid due to ‘bracket creep
Problems with unanticipated inflation
There are winners and losers, depending on whether inflation is higher or lower than anticipated
Problems with unanticipated inflation
those with fixed incomes?
–For example: Those on fixed incomes will lose if inflation is higher than anticipated.
Problems with unanticipated inflation
Borrowers and lenders?
–Borrowers on fixed-term contracts may gain and lenders may lose when inflation is higher than anticipated.
Problems with unanticipated inflation
contracts?
–People on fixed-payment contracts will lose if inflation is higher than anticipated.
Hyperinflation
Extremely rapid increases in the general price level.
what happens In periods of hyperinflation
–money loses value so rapidly that firms and households try to avoid holding it.
Hyperinflation is often associated with
–political instability and usually accompanied by a severe recession and economic and political turmoil.
Deflation:
A decline in the general price level in the economy.
problems with deflation include
- Increases debt burdens
- Reduces asset values and wealth
- Gains to consumers from falling prices may be negated by falling wages
- The real interest rate rises above the nominal interest rate, discouraging business borrowing and reducing the effectiveness of monetary policy
- Long-term deflation can severely erode economic growth
What causes inflation?
Demand-pull inflation
§: Inflation that is caused by an increase in the aggregate demand for goods and services and production levels are unable to meet this demand immediately.
Aggregate demand:
–The quantity of goods and services demanded by households, firms and government, plus net exports.
demand - pull inflation
why may the production be unable to meet demand
§Production may be unable to meet demand, particularly when the economy is close to, or at, full employment.
Demand -pull inflation
what is wage-price sprial
§Upward pressure is put on prices and nominal wages and can lead to a wage-price spiral.
causes of inflation
Cost-push inflation
§Inflation that arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services.
–Aggregate supply: The quantity of goods and services supplied by firms.
Sources of a supply shock can include
–Increases in import prices
–Increases in wages
–Increases in indirect taxation
–Increases in monopoly power in product markets
–Natural disasters, such as droughts, floods and earthquakes
4 biases that cause changes in the CPI to overstate the true inflation rate
- Substitution bias
- quality bias
- new product bias:
- outlet bias
describe substitution bias
The substitution bias is a weakness in the Consumer Price Index that overstates inflation because it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.
they likely substitute away from items that get disproportionately expensive to goods that got comparatively less expensive.
describe quality bias
price from increase in quality
overtime technological advancement increases the life and usefulness of products. CPI does not reflect this
product improvements are under-counted)
For example, an average computer today might cost about the same as an an average computer cost last year, but today’s computer is better than last year’s computer in a number of ways that the CPI doesn’t account for.
what is new product bias
what is new product bias
new products are not introduced in the index until they become commonplace
(new products are not counted for a while after the appear)
what is outlet bias
the consumer shift to new outlets such as wholesale clubs and online retailers
a severe drought reduces the production of tropical fruit, causing the price of tropical fruit to rise significantly
overestimate, substittion bias, becoming consumers would substitute cheaper foods for tropical fruit
new tech signiicantly decreases the price of 3D televisions
accurately reflects a fall in price of consumer goods
consumers switch to buying front loadin clothes washing machines instead of the less water efficient top-loading washing machines, even though the front loading washing machines are more expensive
overestimate, similar to new product bias
or quality bias
Both the inability of the CPI to incorporate technological progress and its failure to account for substitution in consumption decisions imply that, in most cases,
the Consumer Price Index likely overstates increases in the cost of living that households actually feel.
