Inflation

Inflation

 * __Helen__**

**__9.2 – Measuring Inflation__** Inflation is a sustained increase in the general level of prices in an economy CPI (consumer price index) //CPI //– (Consumer price index) Summarises the movement in the prices of a basket of goods and services, weighted according to their significance for the average Australian household. It is used to measure inflation in Australia The annual inflation rate is calculated by the percentage change in CPI over the year

** Inflation rate (%) ** =                   __CPIcy - CPI py__ *100 CPI py  Where CPIcy = the value of the CPI in the current year Where the CPIpy = the value of the CPI in the previous year The basket of goods and services used to calculate the CPI doesn’t include all goods and services available in the economy, but covers a wide selection that reflects average household spending patterns CPI is a good indication of the overall movement in the prices of consumer goods, reflects general changes in the cost of living. CPI compiled by ABS – every 3 months CPI excludes items of household spending – changes in mortgage interest rates, consumer credit charges CPI excludes - property prices Headline (official) rate of inflation Measured using CPI.  Can be misleading indicator of ongoing price pressures in the economy because it includes some g/s whose prices may be highly volatile or affected by one off factors. More volatile Underlying Inflation Preferred by economists Removes the effects of one-off or volatile price movements Less variable than headline inflation More reliable - better indicator of future levels of inflation in the economy. Trimmed mean – calculating average inflation rate after excluding the 15% of items with largest price increases and 15% of items with the smallest price increases from CPI Weighted median – compares inflation rate of every item in the CPI and identifying the middle observation Underlying inflation = average of the two measures Target is the headline inflation level Provides long term view of inflation trends June 2008 – trimmed mean inflation – 4.5% → highest in 17yrs Sustained reduction from early 1990’s, after high inflation in mid 1970’s In lowest inflation rate since the 1960’s 1993 – RBA forms target average of inflation at 2-3% (formed in 1996) over the economic cycle to determine interest rates GST raised inflation slightly The recession on early 1990’s ended the high inflation The target inflation rate influenced RBA policy decisions The RBA has tightened interest rates to slow growth in demand to curb inflationary pressures Global factors – lower inflation - →↑ trade competition Structural change has prevented economic growth, resulting in an increased inflation Microeconomic reform increased intensity of competition within Australia and from overseas, while productivity growth has also improved → low inflation Recent years – increasing inflationary pressures Australian economy – big economic expansion – close to full capacity, with low unemployment Global inflationary pressures due to increase demand fro food, energy resources and commodities Mid 2008 – 4.5% Underlying inflation – highest since 1991 2008 – RBA predicted that it wouldn’t fall to 2-3% until mid 2010 Demand-pull inflation When aggregate demand or spending is growing while the economy is nearing full supply capacity, so that higher demand leads to higher prices rather than more output Consumers then, force prices further as they bid for the limited goods and services Cost- push inflation When there is an increase in production costs, that producers pass on in the form of higher prices, thus raising the rate of inflation Major sources include oil prices and wages When wages increase faster that productivity, the cost of labour for each unit of output increases Wages cost 60% of a firms cost, firms wil latempt to pass on the wage increase to consumers to maintain profitability Inflationary expectations If higher inflation is expected, consumer may react in ways that cause an increase in inflation o  If prices of g/s are expected to increase, consumers will attempt to but before they increase, resulting in higher demand-pull inflation. o  If a firm expects that demand for their product will increase, the firm may rise prices, increasing inflation o  If employees expect inflation to increase, they will negotiate more wage increases, leading to cost pull inflation Imported inflation Transferred through international transactions Caused by import prices, and depreciation of the Australian dollar, increasing the price of imports Imports face competitions from locally made products and importers may reduce profit margins, to limit effect of overseas price rise or depreciation Other causes Government policies – increase in indirect taxes, impact on general level of prices <span style="font-size: 12pt; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; mso-hansi-font-family: Calibri; msoasciifontfamily: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msohansifontfamily: Calibri; msolist: Ignore;"> -   GST temporarily raised inflation <span style="font-size: 12pt; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; mso-hansi-font-family: Calibri; msoasciifontfamily: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msohansifontfamily: Calibri; msolist: Ignore;"> -   Deregulating an industry <span style="font-size: 12pt; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; mso-hansi-font-family: Calibri; msoasciifontfamily: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msohansifontfamily: Calibri; msolist: Ignore;"> -   Changing tariff rates <span style="font-size: 12pt; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; mso-hansi-font-family: Calibri; msoasciifontfamily: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msohansifontfamily: Calibri; msolist: Ignore;"> -   Imposing price controls Excessive increases in money supply – when money supply exceeds economic growth rate <span style="font-size: 12pt; mso-ascii-font-family: Calibri; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; mso-hansi-font-family: Calibri; msoasciifontfamily: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msohansifontfamily: Calibri; msolist: Ignore;"> -   Increase money for the same g/s will cause a price rise Likely to all be operating at the same time, or two more prominent **__ 9.5 – The effects of inflation  __** Higher inflation = more severe consequences Economic growth and uncertainty Excessive economic growth raises inflationary pressures through increased wage demands and strong consumer demand, bidding up price levels Sustained lower inflation, allows moderate economic growth without increasing interest rates Higher inflation distorts economic decision making, since producers and consumers change their spending and investment decisions. E.g. buying assets rather than investing in income producing activities Low inflation removes distortion to investment and savings decisions, which high inflation causes. It restored long term incentive to invest in productive assets rather than short term speculative investment High inflation – discourages business investment because it makes producers uncertain about future costs and profit levels. High inflation – impacts decision to spend or save disposable income. Spend more as purchasing power is reduced Sustained low inflation – encourage saving Wages Major influence on nominal wage demands. In high inflation – employees seek larger wage increase to prevent erosion of purchasing power Leads to wage price inflationary spiral Higher inflation mainly caused by higher wage demands Income distribution Negative impact on distribution of income as incomes don’t rise as quickly as prices Lower income face higher interest rates when inflation rises Hurts those on fixed incomes Erodes value of existing savings, as net wealth will decline Unemployment High inflation – more contractionary fiscal and monetary policies → slower growth → higher u/e in short to medium term W hen there is high u/e → low inflation Low u/e → rising inflation 1970’s → Stagflation – increase in inflation and u/e International competitiveness High inflation→↑export prices→↓ international competitiveness→↓ quantity of exports As price of goods ↑ → consumers switch to imports → worsening trade deficit Low inflation →↑ international competitiveness→ Aus g/s more attractive→ expansion of exports →replace imports with domestic substitutes →↑ trade deficit Exchange rate impacts Short term → high inflation →appreciation of the exchange rate as speculators expect increase in interest rates by RBA → attracting greater financial flows High inflation → currency depreciation over time Low inflation help stabilise the dollar in the 1990’s compared to volatility of the 1980’s Sustained low inflation→ greater international confidence→ strengthening value of the dollar Interest rates Lower inflation →↓nominal interest rates Reduced inflation since 1990’s has led to much lower interest rates Higher inflation → higher interest rates, as the RBA attempts to reduce demand pressures in the economy **__<span style="font-family: 'Calibri','sans-serif'; font-size: 16pt;">9.6- Policies to sustain low inflation __** <span style="font-family: 'Calibri','sans-serif'; font-size: 14pt;"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">the government and the RBA implemented monetary policies in the 1990’s too achieve low inflation <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">In short to medium term, monetary policy is the major tool used to reduce inflation. <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">Has been effective in sustaining growth at a level that doesn’t cause excessive inflationary pressures <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">If inflation starts to rise that RBA can increase interest rates by tightening monetary policy <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">This dampens consumer and investment spending, →resulting in lower economic activity and therefore lower inflation. <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">RBA takes action before inflation becomes a problem <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">E.g. the RBA increased rates ten times between 2005 and 2008 in response to continued economic growth and concerns about demand-pull inflationary pressures <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">RBA has attempted to make use of monetary policy predictable by using monetary policy to keep inflation within its target bad. This lowers inflationary expectation, further reducing inflation as a problem <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">If the government increases revenue and decreases spending, it reduces demand pressures on the economy and can reduce demand-pull inflation <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">It may also support the low inflation objective may also reduce the need for higher interest rates to combat an inflation challenge. <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">used by government <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">has contributed to Australia’s generally low inflation environment <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">Reduced protection has lowered prices of imports and increased competition from overseas producers <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">Deregulation of the labour market has reduced the problem of cost-push inflation <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">Reforms to the labour market attempt to ensure that wage increases are linked to productivity improvements <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">If productivity rises the economy will be able to afford real wage increases without inflationary pressures <span style="font-family: 'Calibri','sans-serif'; mso-bidi-font-family: Calibri; mso-fareast-font-family: Calibri; msobidifontfamily: Calibri; msofareastfontfamily: Calibri; msolist: Ignore;">- <span style="font-family: 'Calibri','sans-serif';">In a deregulated market there are also a strong demand for skilled workers to translate to higher wages in industries with a shortage of skilled workers <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif';"> <span style="font-family: 'Calibri','sans-serif';">The use of various policies, suggests that high levels of inflation are unlikely to return
 * __ 9.3 – Recent trends in inflation  __**
 * __ 9.4 – The main causes of inflation  __**
 * <span style="color: #7030a0; font-family: 'Calibri','sans-serif';">Monetary policy **
 * <span style="color: #7030a0; font-family: 'Calibri','sans-serif';">Pre-emptive monetary policy **
 * <span style="color: #7030a0; font-family: 'Calibri','sans-serif';">Fiscal Policy **
 * <span style="color: #7030a0; font-family: 'Calibri','sans-serif';">Microeconomic reform policies **