Ch 9: Inflation

Question 1

Define inflation

Answer 1

the persistent and appreciable rise in the general level of prices

Question 2

What is Australia’s goal for price stability and what is it currently?

Answer 2

to maintain inflation between 2-3% current inflation rate: 1.5%

Question 3

How is inflation measured and describe the weight system?

Answer 3

> the most familiar method is the Consumer Price index which summarises the overall change in the prices of a large number of goods and services

• g & s are classified into - 11 major groups, 33 subgroups and 87 classes of expenditure
• the ABS attaches a weight to each commodity (and group) in order to reflect its importance in the pattern of expenditure by an ‘average household’
  
  • weight = positive statement
  • higher weight: housing, food, non-alcholic drinks
  • lower weight: clothing, education

Question 4

How is the annual rate of inflation and price index calculated?

Answer 4

price index = price x weight

rate = (Y2 Price Index - Y1 Price Index)/ Y1 Price Index

Question 5

What is demand pull inflation and what is an example?

Answer 5

> rising prices caused by an excessive level of aggregate expenditure compared to the resources available at the time.

High levels of aggregate demand are indicated by:

• high levels of durable consumption spending
• excess demand for labour in some sectors, forcing wages up and thus prices
• excess money supply - rate of growth of money supply is greater than rate of growth of real output

i.e. 2004-2006 building boom: high demand created a relative shortage of skilled building tradespersons so contract prices rose sharply

Question 6

What is cost push inflation?

Answer 6

> rising production costs are passed on to consumers, who then have to pay higher prices for final g&s. It affects aggregate supply and the costs reflect the prices for productive inputs.

Periods of cost push inflation can be attributed to:

• wages increasing more than productivity
• when the price of imports (resources/capital) rises (perhaps as a result of depreciation of the domestive currency)
• government charges and taxes rise (i.e. GST and carbon tax)
• when oil prices rise, as oil is a significant production and distribution cost

i.e. rapid increase of oil prices rom $25/barrel in 2003 to $147 in July 2008

Question 7

What are the output effects of inflation?

Answer 7

> inflation impacts on level of output, income and employment

• real income falls - if prices rise faster than income
• economic efficiency and the level of production in the economy - inflation directs resources away from productive activities to speculative activities due to uncertainty to productive decisions
• promotes uncertainty - savings and investment discouraged (potential economic growth reduced), investment decisions w capital expenditure more risky -> affects expenditure and income, reduces output and employment opportunities
• capital-for-labour substitution - occurs when wages rise faster than productivity i.e. 2007-2012 mining boom, companies employed remote-controlled trucks
• lack of confidence in money as a store of value - consumers purchase assets which are likely to appreciate in value, speculative activity can have a negative impact on the potential output of the economy if speculation becomes an easier way to create wealth than innovation and risk-taking in real markets
• real interest rates - if inflation rises, this places upward pressure on the nominal and real interest rate (bc premium for risk rises)
• international competitiveness - country is at a disadvantage if its domestic inflation is greater than its competitors
• economic collapse - due to hyperinflation (when above 30%), happens if there is a diversion of effort towards hoarding or non-productive activity

Question 8

What are the redistribution effects of inflation?

Answer 8

> inflation affects the distribution of income and wealth

• the burden of inflation does not fall evenly on all sectors of the community
  
  • those groups who are able to anticipate may be able to benefit from expected price increases also sectors w more market power seem more capable of maintaining their real incomes i.e. aggressive trade unions
  • living standards of low income earners and recipients of transfer incomes (pensions) will fall unless these payements are indexed to the price index
• creditors lose - because the value of the meny they lend loses value
• debtors gain - because they can build up their assets on borrowed money, knowing that the real value of their repayments will fall over time
• ‘pay as you go’ taxpayers will suffer bracket creep as income levels rise to levels where they are liable for higher marginal rates of taxation
• govt. benefit for greater revenue
• effects depend on how well price increases were anticipated by the community

Question 9

What does demand pull inflation look like?

Answer 9

Question 10

What does cost push inflation look like?

Answer 10

Question 11

Define aggregate demand v aggregate supply:

Answer 11

aggregate demand: the total amount of spending in the economy from all the different sectors

aggregate supply: the relationship between the total output of g&s that producers are willing to produc and the general price level