8. Inflation

• Inflation

  Persistent and appreciable rise in the general level of prices over time
• Consumer Price Index (CPI)

  Weighted index based on proportion of income spent on a particular group of items<|>Measures changes in the price of a basket of goods and services bought by households from one quarter to the next
• CPI

  • Attaches weight to each commodity to reflect importance in pattern of expenditure in an average household
  • Weights change depending on preference or reaction to changes in price
• Calculating CPI inflation rate

  Ø (CPI(yr2)-CPI(yr1))/(CPI(yr1)) × 100 (%)
• Headline measure (CPI): The measure that is reported by the media
• Underlying measure: excludes volatile and temporary price changes to best reflect market forces.
• Trimmed mean: remove the most volatile 15% of items from each side of the CPI, look at the remaining 60%
• Weighted median: only look at the price changes change in middle 50th percentile by weight
• CPI excluding volatile items: which is the average inflation rate of all items in the CPI basket except for fruit, vegetable and fuel are usually very volatile because they are often affected by supply disruptions, such as unusual weather or changes in how much oil is supplied to the world market. The CPI excluding volatile items always removes the same items
• Limitations of CPI

  • Only reports price movements in metro areas
  • Does not account for quality of goods and services - only price
  • Not regarded as "true" cost of living index
  • Does not reflect changing consumer preferences or substitutes
• Demand Pull Inflation: Excess of aggregate demand over aggregate supply at the full employment level of output, and is caused by an increase in aggregate demand.

  When AD increases and hence AD is > AS

  Give aggregate examples, e.g. Stimulus payments instead of toilet paper

  "Too much money chasing too little goods"
• Demand Pull Inflation: Rise in the general price level resulting from an excess of demand over supply of will also push wage prices up with higher demand for labour
• Demand Pull Inflation: Government can increase interest rates to control
• Cost Push Inflation - supply side

  • Caused by a fall in aggregate supply, in turn resulting from increase in wages or prices of other inputs (e.g. Oil, floods)
  • Rise in production costs are passed on to consumers who have to pay higher prices for final goods and services.
• Covid reached a high of 7.8% inflation. Driven by both cost push and demand pull. Supply chain issues reduced supply/increased the cost of goods, and government stimulus and savings drove consumer demand.

  • Cost push is harder to reduce and control. With demand side interest rates can be increased to reduce demand, but it is difficult for the gov to influence/change supply.
• Costs of (High) Inflation (Negative): Reduces real income (purchasing power). Buy less goods with same money ==> decrease Standard of living.
• Costs of (High) Inflation (Negative): Affects interest rates

  Real interest rate (nominal interest rate- inflation) must be positive for lenders to make profit and lend.

  But if it is positive/increasing, more money is spent on payments, reducing real income.
• Costs of (High) Inflation (Negative): International competitiveness

  Country's exports at disadvantage when domestic inflation is greater than overseas

  Loose competitiveness, exports reduces, GDP reduces
• Costs of (High) Inflation (Negative): Currency depreciation

  Less overseas demand for country's goods, less demand for AUD, causing AUD to depreciate
• Costs of (High) Inflation (Negative): Capital for labour substitution

  Due to wage inflation and structural change (structural unemployment)

  Wages are increasing, so they get rid of workers to cut costs.
• Costs of (High) Inflation (Negative): Uncertainty for decision makers

  Investment decisions, reduce output and employment opportunities

  This is why we want constant low inflation
• Costs of (High) Inflation (Negative): Economic efficiency

  People move away from productive to speculative activities (assets, investment): negative impact on economic output

  See less value in money, but assets (like housing) are increasing in value
• Costs of (High) Inflation (Negative): Hyperinflation (about 30% p.a.)

  Diversion of efforts towards hoarding or non-productive activities
• Costs of (High) Inflation (Negative): Reduction in income equality

  Bracket creeps: as income rises with inflation, higher margin of tax leading to fewer tax brackets.

  Pay more tax without actual increase in real income
• Benefits of Low, Stable Inflation: Helps to maintain low real interest rates

  • Supports economic confidence
  • Encourage higher levels of consumption an investment 
• Benefits of Low, Stable Inflation: Creates confidence about growth of economy 

  • Assets like houses increase in value over time
  • Changes in price are predictable
• demand PULL
• cost PUSH