HSC Economics, Topic 3: Economic Issues, Part Three

Inflation

Measurement – current Australian Bureau of Statistics measure

 Inflation refers to a sustained increase in the general price level over time
o General price level is the average level of prices in an economy

Measurement of inflation

 Consumer Price Index (CPI)

o A measurement of inflation drawn from changes in the prices of a representative basket of consumer g/s over time,
weighted according to their level of importance to the average Australia household
o Nature:
 Measures changes in prices of a representative basket of consumer g/s over time
 Uses price index numbers
 Movement reflects general change in the cost of living
o Expressed as:
 Headline rate of inflation (HRoI)
 Refers to rate of change in the CPI
o Calculated quarterly by RBA, ABS
o Compared w base yr, index of 100
 HRoI (%) = CPICY - CPIPY/CPIPY x 100
o CPICY = the value of the SPI in the current yr
o CPIPY = the value of the CPI in the previous yr
 Measures price changes in eleven main categories: food (15%), clothing and footwear (4%), alcohol
and tobacco (7%), housing (20%), household contents and services (10%), health (5%),
transportation (13%), communication (3%), recreation (12%), education (3%), financial and
insurance services (9%)
o Categories weighted according to importance in average HH expenditure
o Rate of change in each group added together for average
 Measure price changes in eight capital cities, excludes rural areas
 Limitations of HRoI
o Can be a misleading indicator
 Highly volatile
 Influenced by one off factors (eg change in rate of gov tax )
 Underlying rate of inflation (URoI)
o Refers to rate of change in the CPI excluding one off or seasonal factors
 Excluded factors:
 High food prices due to drought
 Gov induced tax changes
 No official measure
 Calculated by RBA, federal treasury using the CPI
 More accurate measurement of LT trends in inflation
 Less variable
o RBA calculation of URoI
 Average of two measures:
 Trimmed mean (average inflation rate excluding 15% of items w largest price increases, 15% of
items w smallest price increases)
o 4.3% in June 2008
 Weighted median (middle percentage price increase assessed)
o 4.5% in June 2008
 Calculation of inflation by RBA
o 1993-98
 ‘Outlays approach’
 2-3% average underlying inflation over economic cycle
 Limitations:
o Included price of mortgage interest, consumer credit
 Eg rise in IR, rise in mortgage interest, perverse rise in CPI
o Limited transparency of inflation targeting policy as there is no official calculation for URoI
o Poor public recognition of target rate
 Advantages: accounts for one off, seasonal variations in rate
o 1998-present
 ‘Acquisitions approach’
 2-3% average headline inflation over economic cycle
 Limitations: fails to account for one off, seasonal variations in rate
  Advantages:
o Improved public recognition of target rate
o Improved transparency of inflation targeting policy
o Excludes variable factors including mortgage interest, consumer credit

Trends

Recent trends in inflation

 Historical overview
o 1970-80: high level of inflation
 Annual average of 6-10% over two decades
 Recent trends
o 1990-2006: sustained low inflation
 Annual average of 2.6% in 1996-06
 Due to:
 Inflation target adopted by RBA in 1993
o Reduced inflationary expectations
o Increased transparency, efficiency, credibility, effectiveness of MP
 Reduction to protection bw 1988, 2005
o Domestic economy exposed to increased competition
 Applies to factor, product markets
 National competition policy passed in 1995
o Increase in competition bw domestic producers
 Introduction of productivity bargaining in 1991
o Reduction to wage cost pressures
o Improvement in productivity
 Successful macroeconomic policy
o Reduction to inflationary expectations
o Improved economic performance
 Technological change, innovation
o Reduction to FoP costs
o Improvement in productivity
o 2006-08: rise in headline inflation above RBA target band
 Increase in CPI
 Statistical evidence
o 1.5% increase in June quarter 2008
o 4.5% increase in year to June quarter 2008
 Due to:
o Increase in food prices due to drought, higher global prices
o Increase in cost of petrol due to rising world oil prices
o Increase in cost of financial, insurance services due to global credit crisis, MP
o Increase in EG above its sustainable rate to 3.7% in 2007-08
 Increase in tradables price inflation
 The extent of price rises for imported g/s
 Statistical evidence
o 2.9% increase in year to June quarter 2008
 Including petrol, food prices
o 1.0% increase in year to June quarter 2008
 Excluding petrol, food prices
 Due to: increase in food, oil prices; high ER; decline in cost of ICT imports
 Increase in non-tradables price inflation
 The extent of price rises for domestically produced g/s
 Statistical evidence: 5.6% increase in year to June quarter 2008
 Due to: increase in price of rent, health, education, financial services
 Despite consecutive rises in IRs in 2007, 2008
o 0.25% increase in cash rate in August, Nov 2007 and Feb, March 2008
 Eg from 6.25% (August 2007) to 7.25% (March 2008)
 Rise in underlying inflation above RBA target band
 Statistical evidence
o 1.0% increase in June quarter 2008
o 4.5% increase in year to June quarter 2008
 Causes of upsurge in inflation
 Strong growth in AD that was not matched by an equivalent expansion of AS
o Economy approaching full capacity
 Supply constrained by limited labour, factor markets
o Increase in world oil, energy prices
 Supply constrained by limited resources, high prices
 o Increase in domestic, global food prices
 Caused by climate change, increase in bio-fuel production
o Growth in nominal unit labour costs, slow down of productivity growth
 4% rise in cost of labour
o Increase in housing costs
 Including rent, construction costs
o 2008-
 Forecasted fall in headline, underlying inflation by federal treasury
 4% in 2007-08 to 2.5% in 2008-09
 Due to decline in global economic growth

Causes
 Demand inflation

Demand pull inflation

 Nature
o Refers to inflation caused by excessive growth in AD
 Growth in aggregate demand > growth in aggregate supply
 Increase in D, increase in price level
o Applies to D side inflation
 Evidence of DP inflation
o 2007-08 rise in DP inflation
 Illustration of DP inflation
o Keynesian model
 Equilibrium level of income denoted by Ye (intersection of AD, AS)
 Full employment level of income denoted by Yf (where AD > AS)
 Inflationary gap at cd
 Rise in inflation equivalent to cd

o Classical AD/AS model

 Equilibrium level of real GDP denoted by real GDP1
 Intersection of AD, AS
 Full employment level of real GDP
 Increase in AD from AD to AD1
 Increase in price level from P to P1
 Increase in real GDP from real GDP1 to real GDP 2
 Inflationary gap at cd
 Rise in price level equivalent to cd
  Causes of DP inflation
o Excessive growth in one or more of the components of AD
 Increase in consumption expenditure (C)
 Due to higher consumer confidence, wage increases, tax cuts, fall in IRs
 Increase in investment spending (I)
 Due to higher business confidence, increased depreciation allowances, tax cuts, fall in IRs
 Increase in net government expenditure (G-T)
 Due to tax cuts, rise in gov purchase of g/s
o Eg increase in budget deficit/decrease in budget surplus
 Increase in net export income (X-M)
 Due to increase in ToT, increased investment, consumer expenditure in domestic economy
o Excessive growth in money supply
 Caused by RBA actions to stimulate/dampen consumer, business spending

 Cost inflation

Cost push inflation

 Nature
o Refers to inflation caused by excessive growth in the costs of factors of production
 Decrease in AS; decrease in S, increase in price level
 Due to increase in cost of labour, land, capital; firms pass on increase in cost to consumers as price rises to
maintain profit margins
o Applies to S side inflation
 Evidence of CP inflation
o 1970’s rise in CP inflation; period of stagflation
 Illustration of CP inflation
o Classical AD/AS model
 Equilibrium level of real GDP denoted by real GDP1
 Intersection of AD, AS
 Full employment level of real GDP
 Decrease in AS from AS to AS1
 Increase in price level from P to P1
 Decrease in real GDP from real GDP1 to real GDP 2
o Economy experiences stagflation (decline in growth, increase in prices)
 Inflationary gap at cd
 Rise in price level equivalent to cd

 Causes of CP inflation
o Rise in costs of the factors of production
 Across the board wage increase not reflective of improvement to labour productivity
 Rise in price of imported materials (eg oil, intermediate goods)
 Depreciation of ER
 Increase in cost of imports (eg raw materials, intermediate goods, capital equipment)
 Rise in gov charges (eg taxes, freight rates, royalties, workers’ compensation premiums)
 Rise in general level of IRs due to contractionary MP
 Rise in cost of borrowing for firms

 Imported inflation

Imported inflation

 Nature
 o Refers to inflation transferred to Australia through international transactions (eg exchange of imports, exports)
 Evidence of I inflation
o 1973-74 rise in I inflation due to first OPEC oil price shock
 Reduction to supply of oil, increase in cost of energy, increase in cost of final goods
 Dependent on magnitude of oil as an input
o Eg used to transport, distribute good
 ‘Second round’ effects of higher oil prices
o 1979-80 rise in I inflation due to second OPEC oil price shock
o 1986 rise in I inflation due to large depreciation of ER
 Causes of I inflation
o Rise in price of imported consumer goods
o Rise in price of imported intermediate goods, capital goods, raw materials
 Upwards pressure on price of domestically produced goods
o Depreciation of Aus $
 Increase in domestic price of imports

 Inflationary expectations

Inflationary expectations

 Nature
o Refer to people’s perceptions of future inflation based on past and current rates of inflation
 Evidence of IE driven inflation
o 2007-08 rise in IE driven inflation (eg rise in oil prices)
 Causes of IE driven inflation
o Increase in IE for consumers, firms
 Consumers bring forward purchase of g/s
 Increase in D; DP inflation
 Firms raise prices to maximise profits
 Decrease in S; CP inflation
o Increase in IE for employees, employers
 Demonstrated by short/long run Phillips curves
 SR Phillips curve
o Inverse relationship or ‘trade off’ bw inflation, UE in SR
 Eg increase in inflation, proportional decrease in UE
o Expansionary macro policy will reduce UE, increase inflation proportionally

 LR Phillips curve
o No ‘trade off’ bw inflation, UE in LR
 UE can only be reduced through: reduction to inflation; increase in flexibility of
labour market
 Expansionary macro policy will only increase inflation
o Increase in IE will increase inflation in LR
 Economy operates at natural rate of UE (a)
 Expansionary macro policy through increase in spending, reduction to tax
 Rise in IE to 2%, fall in UE to 5% in SR (b)
 Workers D increase in nominal wage to maintain real wage
 Rise in UE to 6% due to reduction in D for labour (c)
 UE rate is at natural rate, inflation rate has increased
  May lead to wage-price inflation spiral
 Eg runaway, galloping inflation
o Excessive intensity of spiral may lead to hyper-inflation
 Increase in AD, increase in DP inflation, employees anticipate rise in inflation, employees seek
higher nominal wage to maintain real wage, fall in AS, increase in CP inflation, etc.

Effects

Effects of inflation

 Economic growth
o Inflation is a constraint on EG
 Excessive EG, increase in AD, increase in DP inflation, increase in IE of wage-earners, increase in nominal
wages, increase in CP inflation, increase in unemployment, etc.
o High inflation distorts economic decision making
 Spending, investment patterns of consumers, firms become more erratic
 Decisions are based on IE as firms, consumers attempt to reduce the potential effect of future price
rises
 Eg anticipated increase in inflation
 Increase in investment in speculative assets, decrease in investment in income-producing activities
o High inflation discourages business investment in long term productive assets, encourages business investment in short
term speculative assets
 Uncertainty pertaining to future profit levels
 Due to high IE environment
o High inflation distorts consumers’ decisions to spend or save disposable income
 High inflation encourages spending
 Reduction to purchasing power of money over time
 High inflation discourages saving
 Reduction to purchasing power of money over time
 Quality of life
o High inflation reduces quality of life
 Decrease in real wage
 May lead to increasing D for nominal wage increase
o Eg wage-price inflationary spiral
 Decrease in real income
 Loss of purchasing power
o Increase in cost of living, reduced standard of living
 Decrease in savings
 High level of debt
 Unemployment
o High inflation will cause a decrease in UE in the short term
 Inverse relationship as described by SRPC
 Eg increase in inflation, proportional decrease in UE
o High inflation will not directly influence UE in the long term
 Relationship described by LRPC
 Eg expansionary macro policy will only increase inflation in LR
 Due to inflationary expectations of employees
 External stability
o Impact on international competitiveness
 High inflation relative to export competing economies will reduce IC of Aus exports
  Due to rise in price of Aus exports relative to competing exports
 Reduces quantity of exports
o Impact on ER
 High inflation may cause an appreciation of the ER in the SR
 Increase in investment in Aus
o Speculators anticipate rise in IR
 High inflation may cause a depreciation of the ER in the LR
 Gradual decline in value of Aus $
 Due to purchasing power parity theory
o ER in LR will change to reflect real purchasing power of currencies
 Economies w high inflation should experience depreciation relative to
economies w lower inflation rates
o Hypothetical example
 ER, inflation rate initially equal in Aus, NZ
 NZ experiences inflation
o Rise in cost of a car in NZ relative to Aus
 Increase in D for Aus car by NZ buyers
o Increase in D for $A
 Appreciation of Aus currency
 Purchasing power becomes equal in both countries
o Impact on the CAD
 High inflation has a negative effect on the CAD
 Deterioration of BOGS
o Due to decrease in exports, increase in imports
 Decline in IC of exports, import competing substitutes
 Deterioration of net income
o Incline in IR causes increase in foreign investment in Aus
 Distribution of income
o High inflation will redistribute income away from wage earners, fixed Y earners to those receiving profit, dividend Y
o High inflation will increased inequality in distribution of income amongst wage earners
 Income for low-income earners will rise slowest
 Greatest reduction to purchasing power
 Income for high-income earners will rise fastest
 Smallest reduction to purchasing power
o Eg incomes are indexed to rise w inflation
o High inflation will reduce the net wealth of savers if nominal IRs do not rise accordingly
 Net worth of net savers will decrease faster than net worth of net spenders
 IR impacts
o High inflation causes a rise in the nominal IR
 Nominal IR = real IR + inflation
 Rise in inflation, rise in nominal IR
o High inflation causes a rise in the cash rate
 Contractionary MP by RBA involves increasing the cash rate
 Rise in general level of IRs

Government policies to reduce inflation

 Macroeconomic policy
o Monetary policy
 Tightening of monetary policy
 Conducted through: increase in the official cash rate
o Immediate rise in general level of short terms IRs
o Gradual rise in general level of long term IRs
 Anticipated effect: decline in AD; DP inflationary pressures
o Reduction to business borrowing, investment
 Decrease in I component of AD
o Reduction to household borrowing, consumption
 Decrease in C component of AD
o Increase in household, business savings
 Increase in S leakage of AD
 Illustrated example:
o 1% rise in cash rate bw August 2007, March 2008
 From 6.25% to 7.25%
o Due to high level of DP inflation
o Reduced D for credit, levels of consumption, investment
 Effects appeared in mid 2008
o Fiscal policy
 Contractionary fiscal policy
  Conducted through: increase in surplus or decrease in deficit of budget outcome
o Through increase in level of taxation or decrease in level of gov expenditure
 Anticipated effect: decline in AD; DP inflationary pressures
o Reduction to gov expenditure
 Decrease in G component of AD
 Illustrated example:
o Contractionary fiscal stance of 2008-09 federal budget
 Decline in gov expenditure as a percentage of GDP
 From 24.9% to 23.8%
 Political decision
 Rise in nominal gov revenue
 From $303.8b to $319.5b
 Due to automatic stabiliser of personal income tax
o Eg increase in employment, increase in income tax, increase
in gov revenue
 Increase in surplus of budget outcome
 From surplus of $20.4b (2007-08) to $23.1b (2008-09)
 Political decision
 Microeconomic policy
o Conducted through: microeconomic reform
 Examples include:
 National competition policy
o To promote competitive conduct in markets
 Reduction to protection
o To increase IC of domestically produced import competing products
 Taxation reform
o Eg reduction to indirect taxes
 Reform of public services, utilities
o To stimulate increase in productivity, efficiency
 Deregulation of markets
o To increase competition; productivity, efficiency
 Deregulation of labour market
o To promote increase in productivity, efficiency
o Anticipated effect: reduction to CP inflation
 Due to higher levels of productivity, efficiency, competitiveness
 Eg decline in cost of factors of production
o Illustrated example:
 2008-09 federal budget
 National fuel watch scheme, national grocery watch scheme
o Better public awareness of price movements
 Reduction to IE; speculative investment, consumption
 ACCC inquiry into grocery prices
o Better public awareness of price movements
 Reduction to IE; speculative investment, consumption
 Prices and Incomes Accord (1983-1995)
 Set annual targets for growth in aggregate wages
o Ensured that wages kept pace w rate of inflation
 Effectively reduced CP inflation, IE driven inflation
 Workplace Relations Act (1996) and Workplace Relations (WorkChoices) amendment act (2006)
 Increase in reliance on productivity bargaining
o Increase in efficiency, productivity of labour
 Effectively reduced CP inflation