Inflation

• •Economists define inflation as a persistent and appreciable rise in the general level of prices

  •Target is between 2-3%
• •In Australia, levels of inflation have been less than 3% per annum since the early 1990s
• •During the 1970s-1980s, inflation averaged 8% per annum – this had significant consequences for our economy
• •Opposite of inflation is deflation – general level of prices falls
• •inflation measured using Consumer Price Index (CPI)
• •The CPI measures changes in the prices of a basket (sample) of goods and services bought by Australian households from one quarter to the next
• •The list of items covered in the CPI basket ranges from steak to motor cars, and from dental fillings to restaurant meals

  •In the current series, the basket’s items are classified into eleven major groups, 33 subgroups and 87 classes of expenditure
• •The prices of the items in the basket don’t have equal importance

  
• •The prices of the items in the basket don’t have equal importance

  •The average person would consider a 10% rise in the price of fuel to be more significant for their household than a 10% rise in the price of hire cars

  •As a result, the ABS attaches weight to each commodity in the CPI basket in order to reflect its importance in the pattern of expenditure in an average household

  •Weights based on household expenditure survey
• •The ABS reviews the weights every year to ensure the goods and services in the basket are an accurate reflection of average household buying patterns
• Over the past couple of years there has been a shift away from spending on goods towards services
• Following the onset of the COVID-19 pandemic


  There was strong demand for goods such as household appliances, furniture and audio visual and computing equipment
• Lockdowns and border closures

  Spending fell for services such as restaurant meals and holiday travel
• This resulted in the contribution of Goods reaching 58% of the CPI basket and 42% for Services
• For the 2024 updated CPI weights, the contribution of Goods has fallen to 54.5% and Services increased to 45.5%
• The changes in CPI weights reflect spending patterns closer to the pre-COVID-19 period
• •Weight of each item is determined by how important that type of product is for average household

  •Weight is then multiplied by price of that item (WXP)

  •Total expenditure is then calculated ($80 in period 1)

  •Period one is called the base period and is allocated the index number 100

  •The base period is that to which others will be compared – usually a year

  
• •To calculate the price index for period two, the total household expenditure for that period ($90) is expressed as a proportion of expenditure in the previous period ($80)

  •The index number is for period 2 is (90/80 x 100) 112.5

  •Note that the index is a summary measure – food prices rose 23% while recreation rose 10%

  
• •The rate of inflation is simply the rate of change in the price index from one period to another

  •In this example, the rate is 12.5% because (90/80) = 1.125

  •1.125 x 100 = 112.5

  •112.5 – 100 = 12.5%

  •The rate of inflation (the rate at which prices are changing) is calculated from the CPI

  
• inflation calculations

  
• •The CPI is the headline measure of inflation in Australia – define as the broad measure of changes in the cost of purchases made by wage and salary households in capital cities

  
• •Price movements across the groups don’t move in a uniform matter – some rise while others fall

  
• •The ABS adjusts the headline data to account for seasonal price movements (such as fruit and vegetables) and volatile prices such as automotive fuel prices and housing costs

  •The underlying inflation rate gives a better picture of the true rate of inflation
• •Apart from headline and underlying inflation, the ABS calculates trimmed mean and weighted median measures

  •The trimmed mean is calculated by arranging all price movements from largest to smallest then ‘trimming away’ the top 15% and the bottom 15% of price movements. Trimming removes the impact of irregular price movements

  •The weighted median is the rate of price change of the item at the middle of the price changes in the CPI basket – 50th percentile

  
• Limitations:

  •The CPI only reports price movements in metropolitan areas, and is not regarded as a true cost-of-living index because it does not reflect changing consumer preferences or the substitutions which consumers make from day to day in response to relative price changes (such as consumers switching from bananas and apples if price of bananas rise due to a cyclone)

  •Cannot account for changes in the quality of goods over time and is thus likely to overstate price increases
• Causes and types of inflation:

  • demand pull
  • cost push
• •The simple description of demand pull inflation is ‘too much money chasing too few goods’ – households spending more than they normally would, causing prices to rise due to competition for the goods and services available
• •Causes of demand pull inflation include:

  •High levels of consumer confidence

  •Low levels of spare capacity in key industries

  •Rising wages that increase disposable income

  •High levels of credit use – high borrowing

  •Rises in property or share market asset prices that may cause spending to increase due to wealth effect

  •Each of these suggests excess demand for the resources available at the time and would therefore bid up the price
• •Excess demand occurs in both producer and consumer markets

  •If there is a high level of demand for labour, the relative shortage of workers forces their prices (wages) up

  •Some industries/sectors are more affected than others

  •In the mining construction boom of 2011-2014, companies had to pay high wages to attract qualified workers to remote regions – bid up the price of labour (wages)
• •Cost push inflation occurs when rising production costs are passed on to consumers, who then pay higher prices for final goods and services
• Causes of cost push include:

  •Rising oil/petrol prices

  •Rising import prices as a result of a depreciation of currency

  •Wages rising faster than worker productivity

  •Natural disasters such as flood or drought, which causes shortages of agricultural products or disruption to freight lines

  •Unanticipated events are known as supply shocks – Ukraine/Russia war, floods over east
• •In practice, it can be difficult to distinguish demand pull and cost push instances of inflation

  •For example, a wage rise will increase the cost of supply for businesses but it will also increase the income of households and therefore increase aggregate demand
• effects of inflation:

  •Reduces real income

  •Increases interest rates

  •Decrease international competitiveness

  •Depreciation

  •Capital for labour substitution

  •Uncertainty

  •Impact on economic efficiency

  •Bracket creep

  •Hyperinflation in extreme cases
• Reduces real income

  •Inflation reduces purchasing power if incomes do not rise in line with prices

  •If prices rise faster than incomes, real income falls and households cannot purchase the same volume of goods and services they were able to in the past

  •An inflation rate of 3% this year means that one dollar will have 97 cents worth of buying power next year
• Increase in interest rates

  •Inflation affects interest rates because lenders must maintain a margin between their true cost of funds and the rate at which they lend those funds

  •If the interest rate were 7% and prices were rising 8%, the purchasing power or money would fall faster than the rate at which the loan is repaid, so no one would be willing to lend money

  •The real interest rate (nominal interest rate minus inflation rate) must be positive

  •So rising prices place upward pressure on the nominal interest rate
• Decreases international competitiveness

  •International competitiveness is influenced by relative inflation levels

  •Assume an importer could buy a good from either Aust or NZ, and her decision is made on the basis of price

  •A country is disadvantaged if domestic inflation is greater than its competitors

  •See a demand for exports fall as prices rise
• Depreciation

  •Inflation results in a depreciation

  •Exporters win as their product is cheaper so they sell more

  •Importers lose as they can buy less for the same price
• Capital for labour substitution

  •Ongoing wage inflation may cause capital-for-labour substitution where employers may replace labour with machines which don’t ask for pay rises

  •Rising costs have been responsible for other structural changes in the economy

  •Worldwide oil price shocks in the 1970s hastened innovation in energy saving techniques and started the demise of the large car in favour of smaller, more fuel-efficient vehicles 
• Uncertainty

  •Both savings and investment are discouraged, reducing potential economic growth

  •Investment decisions are more risky in an inflationary environment because uncertainty about future costs and prices means decision-makers are certain about the rate of return that can be earned

  •If high inflation leads to higher risks associated with investment, leads to reduced output and employment opportunities
• Impact on economic efficiency

  •This is explained by the uncertainty which continual price increases bring to productive decisions, and by the possibility that inflation diverts resources away from productive activities (making of g/s) to speculative activities (buying products because you expect their value to increase)