Chapter 7 Flashcards
Define inflation
A sustained increase in the general of average level of prices
Explain why inflation occurs
Prices of g+s’s will be changing on irregular basis in a modern capitalist economy like Australia’s
Prices rise and fall over certain periods of times for different reasons
Usually the price rises tend to outweigh the price falls to deliver an increase in ‘average prices’ or a sustained increase in the general or average price level over time
What is the governments goal of inflation
The RBA seeks to achieve “stability of the Aus currency” meaning the RBA attempts to ensure that Aus has a stable value of Australian dollar in terms of ‘purchasing power’ over goods and services
The RBA target inflation rate is 2-3% per year on AVERAGE over the course of the economic cycle
Measured by the CPI
Define consumer price inflation
Inflation as it relates to the costs of purchasing goods by consumers
Define consumer price index
An indicator of consumer price inflation and measures the in the price of goods and services purchased by the average Australian household
Why does the RBA target 2-3% growth in consumer price inflation ?
The Aus’t government is keen to avoid economic costs associated with high inflation – as these costs ultimately affect all Australian’s
The RBA focuses primarily on prices faced by consumers of goods + services
It targets this range of inflation because it provides the RBA with flexibility to shift it’s focus away from inflation (allowing to climb towards 3%) in an effort to achieve higher economic + employment growth
This flexibility is required for monetary policy to properly operate within it’s charter and act as a key stabilization policy of government
The range also provide a realistic target that allows for national variations in the rate of inflation over time
Why does the gov’t not target 0% inflation ?
The 3 main factors preventing the RBA from targeting an inflation rate of zero:
Small amounts of inflation allow for reduction in the ‘real’ prices of some goods + services (particularly labour services) without a reduction the ‘nominal’ price (e.g. nominal wage) e.g. during a recession it may be necessary for some wages to decrease as demand for labour falls – however wages are generally ‘downward rigid’ (sticky) in nominal terms thereby causing some unemployment. This means if the economy is experiencing some inflation – the real wage can reduce without a reduction in nominal wage
Some inflation is accounted for by rising quality of goods + services – which may not be fully capture in CPI figures (CPI may be overstating extent of inflation) e.g. inflation of 4% for a year is less of a problem if the quality of goods and services increased by 4%. The ABS will not be able to accurately account for these quality improvements in their calculations
It may create other economic problems – such as growth rates that are too low, increases in unemployment and even ‘deflation’ which has a negative impact on growth and employment as consumers delay purchases in anticipation of future price reductions
Define deflation
A decrease in the average price level over time - opposite of inflation
Define nominal (or ‘real’ prices)
A given value adjusted for any inflationary impact
How does inflation affect living standards
Erosion of Purchasing power
Loss of international competitiveness
Distorts resource allocation
Undermine effectiveness of price mechanism
Less savings (neg implications for future investment mls down
Define purchasing power
The ability of cash or money or income to Aquire goods and services - this erodes overtime with inflation
Explain how inflation affects living standards
-erosion of purchasing power
Erosion or purchasing power is the underlying reason why inflation has negative consequences for the economy and living standards more generally
Inflation means that the consumers of goods + services will be paying more for these products over time, which erodes the purchasing power of any given level of income or cash.
If inflation was 10% over the past year, than any given amount of cash or money today will be able to purchase 10% fewer goods + services compared to one year earlier
This significantly harms those whose income does not increase by the same rate or at the same price as inflation – leading to a reduction in their ‘real wage’
This means that purchasing power of wages falls over time and their material living standards fall – similarly those income earners on relatively fixed incomes – such as those on welfare payments will find it relatively more difficult to pay their weekly essential goods + services = reducing their standard of living
Even if income earners manage to achieve an increase in their wage to compensate for the effects of inflation – many will still loose out due to the effects of the ‘bracket creep’ (also called ‘fiscal drag’)
Define fiscal drag
the process of inflation increasing nominal wages (as workers seek to affect real wages) and pushing some workers into marginal higher tax brackets – this increases the average amount of tax paid by taxpayers and boosts the real value of the federal governments tax revenue
Explain fiscal drag (bracket creep)
Even if income earners manage to achieve an increase in their wage to compensate for the effects of inflation – many will still loose out due to the effects of the ‘bracket creep’ (also called ‘fiscal drag’)
Meaning as an individual receives pay rises they will eventually move into a higher tax bracket – where a higher rate of marginal taxation applies to their income this can have the effect of reducing their ‘real disposable income’
How can inflation affect living standards
- distorting resource allocation
High inflation will tend to result in a less efficient allocation of the nation’s resources – this is because economic agents will continually search for ways to protect against any loss of current or future purchasing power
Investors will be seeking to ensure that there is minimal loss associated with any funds invested in markets - accordingly investment can be diverted way from productive areas that create wealth and jobs (such as investment + business capital) towards those investment opportunities that offer the best protection against inflation, such as gold, artwork and collectables, whose returns typically increase in line with (or more than) the rate of inflation. Inflation will advantage those who have sufficient resources (e.g gold) to ‘beat inflation’
How does inflation affect living standards
- undermine effectiveness of market mechanism
High inflation will also undermine the effectiveness of the price or market mechanism as a means of allocating resources. This occurs because economic agents will be less certain about the real causes of price increases. Consumers will be uncertain weather price rises have occurred due to a rise in the quality of particular products and producers will be less confident about the ability of price rises to provide an accurate signal about profitability of particular products
e.g. wheat farmer who identifies a rise for alternative crops will be uncertain whether this rise could indicate greater level of profits to be made by reallocating resources to these crop or more an indication of an increase in prices ‘across the board’ due to inflation
How can high inflation affect future living standards
- savings
Higher inflation will also also tend to result in consumers devoting more of their spending to current as opposed to future consumption. The erosion of purchasing power will cause more consumers to spend more now to minimize any losses associated with holding money – whose value is falling - consequently they are likely to save less of any given level of income.
This has negative implications for future living standards as there is likely to be a smaller amount of savings available for investment – with lower investment the rate of eco growth sows and MLS will fall in the future
Explain how high inflation affects borrowing money
When inflation is high economic agents will find it more attractive to borrow money – because any borrowing that does take place particularly at fixed rates of interest will see the borrowers paying back less in real terms
e.g. if someone borrows $10,000 at an interest rate of 10% this would see the lender receive $1,000 in interest earnings
How does inflation affect living standards
- loss of international competitiveness
Inflation that is greater than the level being experienced by Australia’s trading partners will tend to worsen our international competitiveness – this means that Australia’s ‘tradable’ sector made up of exporting firms and import competing firms will find it increasingly difficult to maintain their market share in the global economy
Inflation is likely to translate to higher export prices, encouraging foreign buyers to switch to cheaper buyers (importers) this combined effect results in lower net export income lower growth in AD or real GDP and negative affect on employment growth – overall the growth in national income levels will be smaller (or may even fall) and the ability for Aus’t to improve their MLS will be harder – this particularly applies to those individuals exposed to the traded goods sector of the Aus’t economy (exporters + businesses competing with importers)
Explain a wage price spiral
High inflation tends to increase the likelihood of an economy experiencing negative effects of a wage-price spiral. This occurs when workers are concerned about the erosion of their purchasing power of their wages and demand higher wage outcomes during inflationary periods
If employers agree this demands the cost of labour increases for businesses and these costs are often passed onto the consumer in the form of higher prices
The cycle of higher prices and higher wages is then established and can be difficult to break a wage price spiral
However this was more a predominant problem when Australia has a more centralized industrial relations system characterized by greater union power
Define a wage price spiral
the cycle of higher prices (or inflation) that causes an increase in nominal wages (as workers seek to protect their real wage) that in turn causes higher business costs and higher prices
Explain inflation and interest rates
During periods of high inflation, nominal interest rates will start to increase as lenders seek to maintain the real rates of return on their investment. Simply lenders want to ensure that they are compensated for the effects of inflation
The change in interest rates occurs automatically in financial markets – however the RBA will be keen to reduce the interest rates across the economy
Consequently the RBA action an normal market pressures will combine to raise interest rates restrain growth in AD, reduce eco activity and decrease living standards in the short term
How does high inflation affect other gov’t goals
Full employment
Strong and sustainable Eco growth
Quotable distinction of income
High inflation will have a negative effect on the governments goal to achieve ‘strong sustainable eco growth and as a consequence will make it more difficult for the government to achieve ‘full employment’
With higher rates of inflation we would expect to see a less ‘equitable distribution of income’ – this follows from having relatively higher rates of unemployment and the negative impact this has on the number of government welfare recipients. Further many low income low income groups (on fixed incomes) will experience a relatively bigger erosion of their purchasing power compared to other groups. Further low income earners will spend a greater proportion of their incomes on goods + services compared to ‘higher income earners’ – this means they have a higher ‘marginal prosperity to consume’ or a ‘lower marginal prosperity’ to save. As a result lower income earners will suffer a bigger relative decline in the purchasing power of their income, while higher income earners, will have a greater opportunity to protect the income not spent (savings) by investing in assets who prices rise in line or faster than inflation
Define Marginal prosperity to consume
Measures the change in consumption that would result from one dollar increase in income (a number between 1 and 0)
