Inflation, Interest rates and the labour market

Alternative Price Index Measures

GDP deflator
CPI

GDP deflator

Is an index of prices of all goods/services GDP.
- tells yous how much of the change in the nominal GDP is due to price changes rather than quantity changes

GDP deflator formula

(Nominal GDPt/Real GDPt) * 100

Consumer price index (CPI)

measures the cost of purchasing a given basket of goods and services relative to a base year.

• tells you how expensive consumer goods have become, compared to base year

• measure cost of living

CPI formula

(Pt/P0)*100

Inflation

Refers to the price index rising over time.
- price level of goods/services are rising

Link between CPI and inflation

CPI measures price level ‘How expensive is the basket now?’. Inflation measures rate of change of prices ‘How much more expensive has it become?’

Deflation

Refers to the price index falling over time.
- prices are rising but the rate at which those prices are rising is declining

The Rate of Inflation

1+πt = Pt/Pt-1

Limitations of CPI

Substitution bias - consumers may substitute away from goods that are becoming relatively more expensive, if so this causes fixed-basket CPI to overstate consequences of inflation.
Quality bias - even if notional prices of goods unchanged, rising quality may mean consumers are getting more for their expenditure, again fixed-basket CPI may be misleading

Costs of inflation

Shoe leather costs, redistribution of wealth, bracket creep, menu costs, noise in the price system

Shoe leather costs

The time and effort people expend to reduce the negative effects of inflation on their money holdings.

Redistribution of weatlh

Borrowers (debtors) benefit as they owe the same amount of money but that amount is worth less therefore lenders lose.

Bracket creep

Tax brackets are nominal therefore people move into higher tax brackets even if their real income hasn’t risen

Menu costs

costs incurred in changing prices and planning

Noise in the price system

Inflation makes it hard to tell if a price increase reflects real demand or just general inflation

How does the RBA control inflation?

RBA conducts monetary policy through changes in interest rates
- if inflation is expected to rise above 3%, typically raises interest rates to slow spending and demand
- if inflation rate is below 2%, it cuts rates to stimulate the economy

Interest rates

Are a way of expressing a financial return.
- when you lend money/invest, you earn interest
- the interest rate expresses that return as a percentage of your initial amount

Nominal interest rate

• doesn’t account for changes in. purchasing power (inflation)

Real interest rate

measures how much your purchasing power grows when you lend or invest money.

Real interest rate formula

i-π

Expected real rate

we usually don’t know the price level Pt+1 in the future

Realised real rate

is often measured as i-π using the change in the price level from period t-1 to t

Labour market outcomes

Refer to the results/performance indicators of how people participate in the job market.

• important determinant of well-being

Working-age population (15-64) is divided into 3 labour market outcomes

N = population not in the labour force
E = population employed

U = population unemployed

Labour force

E + U

Participation rate

the fraction of the working-age population that is in the labour force.

Participation rate formula

(E+U)/(E+U+N)

Unemployment rate

the fraction of the labour force that is not employed

Unemployment rate formula

U/(E+U)

Full-time employment

working 35hours or more in usual week

Part-time employment

working less than 35 hours in usual week

Underemployed

either
- part-time workers available for more hours
- part-time workers actually working part-time hours in survey week

Underutilisation

sum of underemployment and unemployment

Simple model of labour market transitions

helps understand how unemployment changes over time - not just how many people are unemployed, but why that number changes

Separation rate (E—>U)

tells us what proportion of employed workers more from employment to unemployment

Find rate (U—>E)

tells us what proportion of unemployed workers move from unemployment to employment

Change in the number of unemployed workers from period t to t+1

Ut+1 - Ut = sEt - fUt [change in unemployment = job losses - job gains]

Steady-state

sE = fU; U = s/s+f

Job destruction channel

firms fire works —> increase in the separation rate

Job creation channel

firms stop hiring new workers —> fall in the finding rate f

3 categories of unemployment

Frictional
Structural
Cyclical

Frictional unemployment

unemployment arises from the job matching process

Structural unemployment

unemployment arises from changes to the underlying structure of the economy, resulting in a mismatch between the skills and capabilities demanded and supplied. This can result from technological advances or changing tastes.

Cyclical unemployment

Unemployment arises from business cycle fluctuations (caused by a lack of aggregate demand)

Full employment

when the market is ‘at capacity’
- occurs when there is only frictional and structural unemployment

Natural rate of unemployment

Is the unemployment rate that occurs when there is full employment