Chapter 8: Inflation Flashcards
What is the price level?
A measure of the average prices of goods and services in the economy.
What is the inflation rate?
The percentage increase in the price level in the economy from one year to the next.
Why is the GDP deflater a broad measure of the price level?
Because it includes the price of every final good and service produced in the economy.
Why is the GDP deflator a broad measure of Inflation?
Because if we want to know the impact of inflation on the typical household, the GDP deflator may be misleading because it includes the prices of products such as iron ore and commercial property that are included in the measurement of GDP but are not purchased by the typical household.
Why is the GDP deflator sometimes seen as a narrow measure?
For other purposes, the GDP deflator is too narrow in that it measures the prices of only those goods and services produced in Australia. However, as we know, consumers purchases many goods and services produced overseas.
What is the consumer price index?
A measure of changed in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities.
What does the ABS use to obtain the price of a representative group of goods and services?
They survey households nationwide on their spending habits. They use the results of this survey to construct a market basked of the types of goods and services purchased by the typical family.
What are the 11 broad categories in which the goods and services in the market basket are grouped?
- Food and non-alcoholic beverages
- Alcohol and tobacco
- Clothing and footwear
- Housing
- Furnishings, household equipment and services
- Health
- Transportation
- Communication
- Recreation and culture
- Education
- Insurance and financial services
What is the CPI formula?
CPI = expenditures in the current year/expenditures in the base year
Is the CPI accurate?
The CPI is the most widely used measure of inflation, however, there are four biases that cause changes in the CPI to overstate the true inflation rate:
- Substitution bias
- Increase in quality bias
- New product bias
- Outlet bias
When is CPI used?
Policy-makers use the CPI to track the state of the economy. Businesses use it to help set prices of their products and the wages and salaries of their employees. The federal government increases unemployment benefits by a percentage equal t o the increase in the CPI during the previous year. In setting child support payments in divorce cases, judges will often order that the payments increase each year by the inflation rate as measured by CPI.
Explain the following CPI bias: substitution bias
In constructing the CPI, the ABS assumed that each month consumers purchase the same amount of each product in the market basket. In fact, consumers are likely to buy fewer of those products that increase most in price and more of those products that increase least in price (or fall the most in price). For instance, when horrific floods (which led to loss of life and housing) destroyed fruit and vegetable crops in Queensland in January 2011, the prices of some fruits, including melons, mangoes and bananas, and some vegetables rose rapidly. In response to the price rise, consumers significantly reduced the quantity of fruits such as melons and bananas they purchased and increased their purchases of other fruits. However, the CPI continued to be consumer goods and services, including melons and bananas, thereby overstating the rate of inflation.
Explain the following CPI bias: increase in quality bias
Over time, most products included in the CPI improve in quality: cars become more durable and side airbags become standard equipment, computers become faster and have more memory, dishwashers use less water while getting dishes cleaner, and so on. Increases in the prices of these products partly reflect their improve quality and partly are pure inflation. The ABS attempts to make adjustments that only the pure inflation part of price increases is included in the CPI. These adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products.
Explain the following CPI bias: new product bias
The ABS updates the market basket of goods used in calculating the CPI only approximately every six years. This means that new products introduced between updates are not included in the market basket. The prices of many products such as smartphones, Blu-ray players and HD televisions, decrease in the years immediately after they are introduced. Unless the market basket is updated frequently, these price decreases will not be included in the CPI.
Explain the following CPI bias: outlet bias
During the mid-1990s, many consumers began to increase their purchases from discount stores. By the late 1990s, the Internet began to account for a significant fraction of sales of some products. If the ABS continued to collect price statistics from traditional full-price retail stores, the CPI would not reflect the prices some consumers actually paid. The acquisition of goods by mail order or over the phone or internet from outlets within and outside the capital city of residence is considered by the ABS to be relatively small. However, where transactions made by such methods are known to be significant (as in the case with airline tickets and holiday accommodation purchases on the internet) prices collected from these sources.
What is 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. The PPI includes the prices of intermediate goods, such as flour, cotton, steel and timber, raw materials, such as raw wool, coal and crude oil. If the prices of these goods rise, the cost to firms of producing final goods and services will rise, which may lead firms to increase the prices of goods and services purchased by consumers. Changes in the PPI therefore can give an early warning of future movements in the CPI.
How do you use price indexes to adjust for the effects of inflation?
Value in (year 2) = value in (year 1) dollars (CPI in (year2)/CPI in (year 1)) e.g. Value in 2016 dollars = $30,000 x (109/59) = $55,423
What is the nominal interest rate?
The stated interest rate on a loan.
What is the real interest rate?
The nominal interest rate minus the inflation rate. It provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate. When a firm is deciding whether to borrow the funds to buy and investment good, such as a new factory, it will look at the real interest rate, because the real interest rate measures the true cost to the firm of borrowing.
For low rates of inflation, a convenient approximation for the real interest rate is:
Real interest rate = nominal interest rate – inflation rate
Does inflation impose costs on the economy?
- Inflation affects the distribution of income
- The problem with anticipated inflation
- The problem with unanticipated inflation
- Hyperinflation
- Deflation
How does inflation affect the distribution of income?
During inflation, some people will find their incomes rising faster than the rate f inflation and so their purchasing power will rise. Other people will find their incomes rising more slowly than the rate of inflation – or not at al – and their purchasing power will fall. People on fixed incomes are particularly likely to be hurt by inflation (e.g. a retired person receiving a fixed monthly pension will have their purchasing power slowly reduced).
What does the extent to which inflation redistributes income depend on?
It depends on whether the inflation is:
- Anticipated = here consumers, workers, firms and governments can accurately predict it and can prepare for it. OR
- Unanticipated = here they do not fully predict it and do not prepare for it.
What is the problem with anticipated inflation?
Even when inflation is perfectly anticipated, some individuals will experience a cost:
- Inevitably, there will be a redistribution of income, as some people’s incomes fall behind and even an anticipated level of inflation.
- Firms and consumers have to hold some money in notes and bank accounts paying little or no interest, for us in ATMs and EFTPOS, to facilitate their buying and selling. Anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation. To avoid this cost, workers and firms will try to hold as little money as possible, but they will have to hold some.
- Firms that print catalogues listing the prices of their products will have to reprint them (menu costs) more frequently. At moderate levels of anticipated inflation, menu costs are relatively small, but at high levels of inflation (such as in developing countries) menu costs and the costs from paper money losing value can become substantial.
- There is an increase in taxes paid by those holds income-generating assets such as bonds, shares and deposits, which raises the cost of capital for business investment. These affects arise because asset holders are taxed on the nominal payments they receive, rather than on the real payments. Similarly, anticipated inflation can lead to a higher proportion of person income being paid in taxation (‘bracket creep’).
What are menu costs?
The costs to firms of changing prices.
