Homework

  • Inflation is a persistent and appreciable rise in the general level of prices over time
    • On the converse, we have deflation

Measurement

  • The most familiar measure of the level of inflation in Australia is the Consumer Price Index
    • It measures changes in the price of a basket of goods and services bought by Australian consumers in a time period
  • Items are classified into eleven major groups, 33 subgroups, and 87 classes of expenditure
    • Different groups and items have different priorities - a rise in fuel prices would have more impact than a rise in cocaine prices (cocaine is illegal, so it has less demand)
    • Thus, the ABS attaches weights to products - these weights may change each year based on a review each December

Headline vs Underlying inflation

  • Headline Measure is the measure reported by the media
  • Underlying inflation better represents market forces
    • Trimmed Mean: removes the most volatile 15% of items from each side of the CPI
    • Weighted median: changes the median by weight
    • CPI excluding volatile items: Average inflation rate of all items in the CPI basket except for fruits, vegetables or fuels (these are very volatile items) - this is all constant, unlike trimmed and weighted median.

Limitations

  • Does not account for quality of goods and services - only price
  • Does not reflect changing consumer preferences or substitutes that consumers make daily
    • it is more likely to overstate price increases.
  • Only reports price movements in metro areas (specifically, capital cities)

Types

  • Demand-Pull
    • 'too much money chasing too few goods' - i.e., households and businesses are spending more than they normally would, causing prices to rise due to competition
    • Indicators are
      • High levels of consumer confidence
      • Low levels of spare capacity in key industries
      • Rising wages that increase disposable income
      • High levels of credit use
      • Rises in property or share market asset prices
    • For demand-pull, different sectors of the economy will be affected differently
    • Will also push wage prices up with higher demand
  • Cost-Push
    • Rising output costs are passed onto consumers, who then pay higher prices
    • Episodes of cost-push can be attributed to
      • Rising oil/petrol prices
      • Rising import prices <-- currency depreciation
      • wages rising faster than productivity
      • natural disasters such as flood and drought
  • Both are very generalised

Effects of inflation

  • Moderate inflation == good for economy
    • it encourages borrowing and consumption
  • Can be a burden if the cash rate (directly influenced by $CPI$) creeps above $4-5%$.
    • Inflation reduces real income or purchasing power
    • It affects interest rates, as the real interest rate (nominal interest rate - inflation) must be positive
      • this means higher rates are good for savers, but bad for borrowers
    • It can affect international competitiveness, as exports are at a disadvantage (relatively) when domestic inflation is high
    • Can result in currency depreciation
      • because there is less overseas demand for a country's good
    • Capital-for-labour substitutions
    • Also, uncertainty and economic efficiency are impacted