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Week 5: CH 8 Inflation - Coggle Diagram
Week 5: CH 8 Inflation
LO#1: Measuring Inflation
1.2 CPI
Definition
measures the % change in the price of a basket of g&s consumed by households
Construction
Calculated by ABS
Published once a quarter
also known as: Cost-of-Living Index
Weighted according to the fraction of a 'typical' family budget
About 1/2 falls into the categories of:
housing
food
transportation
Formula
CPI= Expenditures in the current year / expenditures in the base year
1.3 Accuracy of CPI
4 biases that overstate the true inflation rate
Increase in Quality Bias
Increase in prices reflect improved quality
Over time, products improve in quality
e.g. PCs become faster
New Product Bias
New products introduced in between updates are not included
ABS updates g&s' used in calculating CPI approx. every 6 years
Substiution Bias
Due to demand/supply issues, consumers may buy fewer goods
ABS assumes consumers purchase same about of each product each month
Outlet Bias
ABS collects price data from full-price retail stores
Goods purchased online are considered by the ABS to be relatively small
1.4 PPI
Definition
An avg. of the prices reached by producers of g&s at all stages of the production process
PPI includes the prices of intermediate goods
flour
cotton
steel
raw materials
Changes in intermediate goods, and hence PPI, give an early warning sign of future movements in the CPI
1.1 Definitions & Data
Price Level
A measure of the avg. prices of g&s in the economy
measure the cost of living
Inflation
The sustained increase in the general level of prices in the economy
Inflation Rate
changes in year-on year price level in the economy
LO#2: Adjusting for Inflation & IR
2.2 Nominal Vs Real IR
Difference is important when money is being borrowed or lent
The IR is the cost of borrowing funds expressed as a % of the amount borrowed (or ROR on investment)
To calculate the true return from lending, wee ne to consider inflation
Nominal IR
stated IR on a loan (cost of borrowing or interest recieved
Real IR (RIR)
Nominal interest adjusted for inflation
Thus, Real IR = Nominal IR - Inflation
2.3 A look at the data
When the inflation rate is high, the gap between real IR and nominal IR can become large
Occurred in 2000/2001 --> the intro of GST
Inflation: 6%, Nominal IR: 5%
5%-6%=-1%
2.1 Using CPI to adjust for Inflation
Purchasing power of the $ fall over time as prices rise
i.e prices 30 years ago were (on avg.) much lower than prices today
CPI gives a way of adjusting for the effects of inflation so that we can compare $ values from different years
i.e. Value in 2020 $ = Value in 1990 $ x (CPI 2020 / CPI 1990)
LO#3: Cost & Causes of Inflation
3.1 Inflation's Cost to the Economy
Distribution of Income
If wages rise faster than inflation
purchasing power will rise
If wages rise more slowly than inflation
purchasing power will fall
Above two depends on whether inflation is anticipate or unanticipated
Anticpated Inflation
where consumers, workers, firms & Govs can accurately predict inflation
EG inflation will increase by 1.5% for the next 5 yrs
Workers' wages will go up by 1.5% each yr
Firms will also increase the price of their product by 1.5% to compensate for increased wages
Lender (of loans) will also make the adjustment by changing the nominal IR
menu costs & increased taxes still exist
Unanticipated Inflation
Depends on whether inflation is higher or lower than anticipated
Fixed wage incomes will lose out is inflation is higher than anticipated
Deflation
deflation's a decline in the general price level in the economy
problems
increases debt burdens
reduces asset values & wealth
Gains to consumers from falling prices may be neglected by falling wages
Long term deflation can severely erode eco growth
The real IR rises above nominal IR, discouraging business borrowing & reducing the effectiveness of monetary policy
3.2 Causes of Inflation
Inflation is categorised as demand-pull or cost push
Demand-Pull Inflation
Production levels are unable to meet this demand immediately
Caused by increase in the AD for g&s
Occurs beyond the full-employment (potential GDP) level of output (& creating excess demand for g&s/labour)
Puts upward pressure on prices and wages (a 'price-wage spiral')
Cost-Push Inflation
These factors will lead to a rise in the price level, accompanied by a fall in real GDP & rise in unemployment
Arises as a result of a (negative) supply shock- anything that causes a deacreas in the AS
A negative supply shock occurs the there is an increase in the cost of production, such as increases in...
wages
indirect taxation
import prices
monopoly power in product market
nautural disasters