Chapter 9: Inflation

Question 1

define inflation

Answer 1

Inflation is a sustained increase in the general level of prices in an economy

Question 2

how do you measure inflation

Answer 2

consumer price index (CPI) - measures the movement in the prices of a basket of G&S, wighted according to their significance for the average AUS HH

Question 3

what si the formula for the annual inflation rate

Answer 3

% change in the CPI over the yr:
(current CPI – previous CPI) ÷ previous CPI x 100

Question 4

what is considered in the basket of goods and services used to calculate CPI and why is this significant

Answer 4

does not include all G&S available in the economy, but covers a wide selection that reflects average household spending patterns
- the CPI gives good indication of the overall movement in the prices of consumer goods and reflects general changes in the cost of living (how much consumers have to pay for the G&S they buy)

Question 5

what are the adv of using CPI as a measure of inflation and to monitor inflation targeting

Answer 5

its simple, reflectuve of price pressures at a specific point in time, and widespread public recognition and understanding

Question 6

why is the official or headline rate of inflation (aka CPI inflation) a misleading indicator of ongoing price pressures in the economy

Answer 6

it includes some G&S whose prices are highly variable or may be affected by one-off factors

Question 7

what is underlying inflation/core inflation

Answer 7

measures the general increase in prices over time, which removes the effects of one-off, seasonal or volatile price movements (eg natural disasters, changes in world oil prices)
- underlying tends to be less variable than headline

Question 8

what are two main measures of underlying inflation

Answer 8

the trimmed mean and the weighted median (or an average of the two)
- these measures adjust official CPI figures to give less weight to goods and services that experienced very large rises or
falls in price

Question 9

what is the calculation behind trimmed mean and weighted median

Answer 9

• trimmed mean – excludes the 15% of items with the largest price increases and the 15% of items with the smallest price increases (or largest price falls) from the CPI
• weighted median – compares the inflation rate of every item in the CPI and uses the inflation rate in the middle of the ordered CPI distribution (also taking expenditure weights into account)

Question 10

what is demand-pull inflation

Answer 10

• when AD is higher than aggregate output (more demand than supply means prices go up)
• since excess demand is said to ‘pull prices up’

Question 11

The main causes of demand-pull inflation (ie what are the main causes of higher demand and inflation) are excessive growth in any of the components of AD:

Answer 11

• increases in C - caused by higher consumer confidence, wage increases or tax cuts
• increases in I - caused by higher profits and business confidence
• increases in the money supply caused by RBA action (eg. quantitative easing or monetary
  financing of government debt)
• increases in net gov expenditure - higher gov spending –> larger budget deficit
• increases in export income - growth in cnsumption and income in the domestic ecp

Question 12

what is cost-push inflation

Answer 12

Cost-push inflation is caused by an increase in the costs of the factors of production
- when production costs rise due to increase in wage rates/ increases in cost of raw mats –> AS decreases and higher costs are said to push prices up

Question 13

what is stagflation

Answer 13

The phenomenon of lower growth, higher inflation and rising unemployment
- rare - rising costs of some inputs may be offset by falling costs of other inputs

Question 14

what are common causes of cost-push inflation (ie what are common causes of increases in price of production costs)

Answer 14

• an increase in wages not relfecting improvements in labour productivity (ie when employees are more productive –> profits increase and wages rise, but when the cost of wage increases exceed productivity growth the cost is usually passed onto consumers)
• a rise in the price of domestic or imported raw materials
• a depreciation of the ER (depreciation of AUD) which raises cost of imports
• a rise in gov charges such as taxes
• a tightening of monetary policy which raises the cost of borrowing and debt servicing for firms

Question 15

what are two ways high inflationary expectations can cause high inflation

Answer 15

• consumption increases as consumers bring forward planned purchases in an attempt to avoid higher prices later, resulting in higher demand-pull inflation
• the anticipated increase in price can prompt employees to demand higher wage increases to preserve purchasing power

Question 16

what is a wage price spiral

Answer 16

when workers successfully demand higher wages in response to rising inflation –> buses pass increased costs in the form of higher prices –> workers demand further wage increases –> so on

Question 17

why did the gov have difficulty reducing UE during the 1970s stagflation

Answer 17

attempts to boost output by stimulating AD only added to inflationary pressures

Question 18

what is imported inflation

Answer 18

Imported inflation refers to increases in domestic inflation resulting from an increase in the price of
imports

Question 19

in what 3 main ways can imported inflation occur

Answer 19

• higher global inflation (particularly among major trading partners) will raise the price of imported consumer goods –> raising CPI
• a depreciation of the AUD will increase the price of imports, raising CPI thru an increase in price of imported consumer goods
• an increase in import prices for either of these reasons will increase the price of domestic goods producced using imported inputs

Question 20

How can government policies directly influence the level of inflation?

Answer 20

Through changes in:
- Indirect taxes (↑ taxes = ↑ prices)
- Industry deregulation (can ↑ or ↓ prices)
- Tariffs (↑ tariffs = ↑ prices; ↓ tariffs = ↓ prices)
- Price controls (↑ ceilings = ↑ prices; ↓ floors = ↓ prices)
- Prices of government goods/services (↑ = ↑ inflation; ↓ = ↓ inflation)

Question 21

what is monetary inflation

Answer 21

When the increase
in the money supply outstrips growth in real output, an increased volume of money ‘chases’ the same amount of goods and services (ie when there is increased money supply, prices go up & ppl spend more)

Question 22

what is quantitative easing and quantitative tightening

Answer 22

• Quantitative easing (QE) is a monetary policy where a central bank purchases gov bonds to increase money supply and stimulate eco activity
• Quantitative tightening (QT) is a contractionary monetary policy tool applied by central banks to decrease the amount of liquidity or money supply in the economy

Question 23

which groups in the eco are subject to the negative impacts of inflation

Answer 23

consumers, workers, savers, producers, investors, exporters and governments; and inhibits the achievement of most other economic objectives

Question 24

What effect does low inflation have on economic growth and investment?

Answer 24

Low inflation supports moderate, sustainable economic growth by avoiding interest rate hikes and preserving purchasing power
- reduces uncertainty about future costs and profits –> encouraging long-term investment in productive assets over speculative ones

Question 25

How does high inflation distort economic decision-making?

Answer 25

It causes consumers and producers to shift spending from productive investment to asset purchases (e.g., property), which does not increase output

Question 26

how does high inflation affect consumer saving behavior?

Answer 26

High inflation discourages saving, as cost-of-living pressures make it harder to save and reduced pruchasing power reduces incentive to save - whereas low inflation encourages saving

Question 27

what are the disadv of low national savings

Answer 27

- larger savings-investment gap, forcing domestic firms to borrow overseas --> raises AUS' foreign liabilities and reduce external stability - if workers lose their job and have no savings to fall back on, this creates much greater hardship --> larger contraction in consumer spending

Question 28

What is the paradox of thrift (or paradox of saving)?

Answer 28

When the economy is weak, households save more (to feel secure), which reduces spending and worsens downturns; when the economy is strong, they save less and spend more, potentially overheating the economy

Question 29

what are nominal wages

Answer 29

pay received by employees in dollar terms, not adjusted for inflation

Question 30

how can high inflation rates increase inequality

Answer 30

- low income earners struggle to secure wage increases which match the rise in prices - income is redistributed to those receiving profit and dividend income - low income earners unable to invest in financial assets that appreciate during high inflation such as property or bonds

Question 31

how does high inflation affect the value of savings

Answer 31

It erodes the purchasing power of savings, causing net wealth to decline unless protected by appreciating assets.

Question 32

Why does high unemployment usually lead to low inflation?

Answer 32

Because AD is lower and spare capacity in the labour market reduces wage and cost pressures

Question 33

How can high inflation affect unemployment?

Answer 33

It discourages business investment and economic growth, reducing labour demand and increasing unemployment

Question 34

what is internal balance (or internal stability)?

Answer 34

When an economy achieves both full employment and price stability

Question 35

How can an economy achieve both low inflation and low unemployment?

Answer 35

Through moderate AD growth and long-term supply-side policies that boost productive capacity

Question 36

define international competitiveness

Answer 36

the ability of an economy’s exports to compete on global markets

Question 37

how can high inflation negatively effect exports and imports

Answer 37

- exports become more expensive than imports and less favourable - less exports sold - makes AUS less comepititve - worsen the trade balance

Question 38

What effect does low inflation have on Australia’s trade balance?

Answer 38

It tends to improve the trade balance by expanding exports and replacing imports with local goods, supporting external stability

Question 39

What is the short and long term impact of higher inflation on the AUD?

Answer 39

- short: It may cause the AUD to appreciate as speculators anticipate the RBA raising interest rates, increasing financial inflows - long: The AUD generally depreciates due to weaker export competitiveness and reduced investment inflows

Question 40

what si the formula for real interest rate

Answer 40

nominal interest rate – inflation

Question 41

What are the effects of high inflation on government?

Answer 41

deterioration of budget outcomes and increase in debt obligations: - taxation revenue rises in the ST as consumers pay more GST - gov expenditure increases due to higher cost of providing infrastructure, wages, welfare payments and collective G&S - budget deficit increase gov debt

Question 42

what are the negative consequences of deflation

Answer 42

- gives consumers incentive to delay purchases --> fall in consumption and eco downturn - it increases the real value of debt, adversely impacting indebted households and firms, and discouraging further borrowing - it can cause real wage unemployment if nominal wages remain the same and lower revenue for firms makes labour costs unaffordable (ie say ur wage is 25$. when there is deflation, ur real wage increases, so ur 25$ buys more than before. but ur employer's revenue falls and cant afford ur wage (cos ur wage sticky))

Question 43

What is the RBA’s inflation target and how does it use monetary policy to achieve it?

Answer 43

The RBA targets 2–3% inflation and raises interest rates to reduce AD and dampen inflation when needed - RBA attempted to make its use of MP more predictable by emphasising its policy for inflation to be in tagret band - this has lowered inflationary expectations further reducing inflation as a problem in the eco - increased freq and clarity of its comms with public to manage inflationary expectations

Question 44

how can fiscal policy help keep inflation low

Answer 44

automatically collecting more tax and reducing welfare payments when the economy is strong, which reduces overall spending and demand - government can also make deliberate choices, like delaying tax cuts or spending, or giving subsidies to reduce pressure on prices --> support RBA to control inflation without needing interest rate hikes - gov has to balance helping HHs with cost-of-living pressures while avoiding spending too much and making inflation worse

Question 45

what are some micro policies that have contributed to greater price stability in AUS

Answer 45

- reducing trade barriers - which has lowered the price of imports and increased compeititon - labour market reforms - linking wage growth to increases in productivity (ie if worker more productie --> buses cant afford higher wages without needing to raise prices --> helps control inflation - investment in infrastructure - expansion of transport infrastructure such as roads, railways and ports, reduced bottlenecks or capacity constraints which can restrict AS and add to inflationary pressures - tax reform - GST

Question 46

what global trends may increase inflation in the future?

Answer 46

De-globalisation, ageing populations, climate change, and the costs of decarbonisation