Inflation

• Inflation is the persistent and appreciable (compounding) rise in the general level of prices
• There are two types of inflation:

  • demand-pull inflation - caused by increasing demand, exceeding the current level of goods and services produced (when economy is growing)
  • Cost-push inflation - caused by an increase in the cost of producing goods and services which is then passed onto consumers who pay more (when economy is slowing)
• Factors that might cause high levels of demand (for demand-pull inflation)?

  • increased wages/income
  • increased consumer confidence
  • decreased taxation
  • Upswing/boom (everything associated with this - factors)
• Factors that might cause production costs to rise?

  • natural disasters
  • increased transport cost (particularly petrol prices)
  • wages rising
• AD/AS graphs

  • axis = price level and GDP
  • curves = AS (aggregate supply) and AD (aggregate demand)
  • points = PL (price levels) and O (output)
• Effects of inflation

  • inflation erodes purchasing power
  • inflation disproportionately impacts lower-income households
  • Inflation may cause interest rates to rise
  • inflation lowers debt service costs
• Inflation eroding purchasing power paragraph

  S: Inflation erodes purchasing power by increasing the prices of goods and services over time.

  E: This means that the same amount of money buys less than it did before and its value has decreased.

  E: For example, if cupcakes cost $1 today, and one has an income of $10, they can buy 10 cupcakes, but if inflation causes the price to rise to $2, they can only buy 5 cupcakes.
• Lower-income households

  S: inflation disproportionately impacts lower-income households because they spend a larger portion of their income on necessities.

  E: When prices rise due to inflation, it disproportionately burdens lower-income households, who have less financial leeway, which limits their ability to afford other necessities, such as healthcare and education, or save for the future.
• Example for lower-income households

  E: According to data from the Australian Bureau of Statistics (ABS), in 2019-2020, the lowest-income quintile spent approximately 28% of their income on housing costs, compared to the 15% that those in the highest-income quintile spent.
• Inflation may cause interest rates to rise paragraph

  S: Inflation can cause interest rates to rise because central banks use higher rates to control inflation.

  E: When prices increase rapidly, banks raise interest rates to make borrowing money more expensive, which reduces spending by people and businesses to help stabilise prices and slow inflation.

  E: In the early 1990s, the Reserve Bank of Australia (RBA) increased interest rates to nearly 18% to combat inflation that had surged to over 7%, making loans more expensive, leading to a decrease in expenditure.
• Explain the change in the graph + the effect on the macroeconomy

  1. When (characterisation) + factors + aggregate + evidence
  2. Shortage + something about prices
  3. General level of prices + evidence
  4. Demand-pull or cost-push
  5. importantly, output is... + indicating economy is...
  6. Evidence
• Evidence for demand-pull inflation

  1. Recovery from Covid caused confidence levels to rise and increased AD due to savings during Covid. This contributed to the high levels of inflation in Australia in 2022 where it peaked at 7.8% in the fourth quarter
• Cost-push paragraph

  1. When production costs rise due to increasing petrol prices, rising wages, or natural disasters, aggregate supply will decrease from AS1 to AS2.
  2. Producers can't afford to produce as much output, causing a shortage and passing on higher costs to consumers.
  3. The general level of prices will rise from PL1 to PL2
  4. This is cost-push inflation.
  5. Importantly, output (GDP) falls from O1 to O2, indicating an economy that is worse off/slowing down.
• Cost-push paragraph continued

  6. Cost-push inflation can be seen as a 'double-edged sword', where the economy is slowing (contributing to job losses) AND prices are rising simultaneously.

  7. During covid, border closures and supply issues caused higher transport cost, contributing to rising inflation in 2021-2022, which changed from 1.1% in March 2020 to 5.1% in March 2021
• Demand-pull graph explain

  1. When the economy is in an upswing, confidence and incomes are rising, causing aggregate demand to increase from AD1 to AD2, creating a shortage and putting pressure on prices.
  2. The general level of prices will rise from PL1 to PL2.
  3. This is demand-pull inflation
  4. Importantly, output (GDP) also rises from O1 to O2, indicating that demand-pull inflation is associated with a growing economy.