Lecture 2: Inflation, interest rates and unemployment

Question 1

Price index measures

2 measures

Answer 1

1. GDP deflator
2. CPI - cost of pruchasing a certain basket of G/S’s relative to a base year:
   Pt = ΣPitqi0
   Index = Pt/P0

Question 2

Inflation

Definition, formula and RBA target

Answer 2

Changes in the price index ie. the cost of living
πt=(Pt-P(t-1))/P(t-1)
RBA targets 2-3% on average inflation over time

Question 3

Issue with CP measure of inflation

Answer 3

1. Substitution bias - doesn’t account for the fact that when the price of one good goes up consumers will find a substitute meaning that the old good being in the basket of goods skews the data.
2. Quality bias - doesn’t indicate that the quality of a product may of increased meaning that althought the price has gone up consumers are gaining more value of the product.

Question 4

Costs of inflation

Answer 4

• Decreased real income if wages do not keep up with inflation
• Noise in the market
• Bracket creep - when nominal income growth pushes consumers up into higher tax brackets even with no change in real income growth
• Redistribution of wealth from lenders to borrowers
• Menu costs - costs of changing costs all the time

Question 5

Interest rates

Formulas, expected and realised

Answer 5

(1+r) = (1+i)/(1+π)
r ≈ i - π

Expected (predicting what prices will be in the next period):
1 + rt = (Pt/P(t+1))x(1+it)

Realised:
r = 1 - π

Question 6

Importance of labour market outputs

Answer 6

• Measure of wellbeing
• Important for efficient allocation of labour
• Economic policies assume some notion of full employment

Question 7

Working age formula

Answer 7

= E + U + N

Question 8

Labour force formula

Answer 8

= E + U

Question 9

Participation rate formula

Answer 9

E + U / E + U + N
Labour force / working age

Question 10

Unemployment rate

Answer 10

U / E + U
Unemployment / Labour force

Question 11

Steady state unemployment

Answer 11

s/s+f
s = seperation rate
f = finding rate

Question 12

Change in unemployment

Steady state and normal

Answer 12

U(t+1) - Ut
= sEt - fUt

Question 13

Categories of employment

Answer 13

• Full time = 35+ hours
• Part-time = <35 hours
• Underemployed: part-time but, available for full-time or full-time working part-time hours
• Underutilised = underemployed and unemployed