Week 5: CH 8 Inflation

LO#1: Measuring Inflation

LO#2: Adjusting for Inflation & IR

LO#3: Cost & Causes of Inflation

1.2 CPI

2.2 Nominal Vs Real IR

1.3 Accuracy of CPI

1.4 PPI

1.1 Definitions & Data

2.3 A look at the data

2.1 Using CPI to adjust for Inflation

3.1 Inflation's Cost to the Economy

3.2 Causes of Inflation

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

Definition

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

4 biases that overstate the true inflation rate

  1. Increase in Quality Bias
  1. New Product Bias
  1. Substiution Bias
  1. Outlet Bias

Due to demand/supply issues, consumers may buy fewer goods

Increase in prices reflect improved quality

New products introduced in between updates are not included

ABS collects price data from full-price retail stores

ABS assumes consumers purchase same about of each product each month

Over time, products improve in quality

e.g. PCs become faster

ABS updates g&s' used in calculating CPI approx. every 6 years

Goods purchased online are considered by the ABS to be relatively small

Definition

measures the % change in the price of a basket of g&s consumed by households

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

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)

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

Real IR (RIR)

stated IR on a loan (cost of borrowing or interest recieved

Nominal interest adjusted for inflation

Thus, Real IR = Nominal IR - Inflation

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%

Distribution of Income

If wages rise faster than inflation

If wages rise more slowly than inflation

purchasing power will fall

purchasing power will rise

Above two depends on whether inflation is anticipate or unanticipated

Anticpated Inflation

Unanticipated Inflation

where consumers, workers, firms & Govs can accurately predict inflation

Depends on whether inflation is higher or lower than anticipated

menu costs & increased taxes still exist

Fixed wage incomes will lose out is inflation is higher than anticipated

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

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

Inflation is categorised as demand-pull or cost push

Demand-Pull Inflation

Cost-Push Inflation

Production levels are unable to meet this demand immediately

These factors will lead to a rise in the price level, accompanied by a fall in real GDP & rise in unemployment

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')

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