Inflation

Inflation and current rate

• persistent and appreciable rise in general level of prices- increase in prices over time and over a wide range of goods and services

• causes a fall in the purchasing power of money (rising prices→ same money has less purchasing power)

• 2.1

Disinflation

slowdown in rate of inflation (still increasing but at a falling rate)

Deflation

fall in the average price level

Hyperinflation

excessive inflation (over 100 percent) e.g. Weimer Republic printing money, Venezuela

Measurement of inflation

• CPI

• Measures the percentage change in the price of a fixed basket of goods and services (representing items accounting for a high proportion of household expenditure) typically consumed by metropolitan households.

• Basket represents items that make up a large proportion of household expenditure.

• Calculated and published quarterly by the Australian Bureau of Statistics (ABS).

Process

• collect prices for thousands of items, grouped into 87 categories and 11 groups,

• weighted based on their expenditure shares, reflecting how much of a typical household's total spending goes to each category, with the weights updated annually to reflect changes in spending patterns.

• prices surveyed at 8 major cities in Australia

• quarterly, ABS calculates price changes of each item and aggregates them to work out inflation rate for the entire CPI basket

Weights

1. Housing 22

2. Food and nonalcoholic beverages 17

3. Recreation and culture 13

4. Transport 11

5. Furnishings, household equipment and services 8

6. Alcohol and tobacco 7

7. Healthcare 6

8. Insurance and financial services 5

9. Education 4 (people without kids, public schools)

10. Clothing and footwear 3

11. Communications 2

Calculating inflation

• (price (y2)- price (y1))/ price (y1) *100

• to calculate for a basket including 2+ items: (inflation ratepercentage weighting) + (inflation ratepercentage weighting) etc.

• e.g. basket includes books, weighted 27 %, and childcare weighted 73%. Childcare’s annual inflation rate is 4.7% and books’ annual inflation rate is 2.5%. Find the inflation rate for this CPI basket.

• inflation = (4.70.73) + (2.50.27) = 4.1 %

Price index

• average change over time in price, base 100, allows comparison over time/ between regions by revaluing a fixed set of goods and services in current prices.

Limitations of CPI

1. Doesn’t indicate price levels

2. Coverage

3. Quality changes

Doesn’t indicate price levels

Measures the rate of price changes in the economy, but not the changes in price levels. e.g. eggs have price index 180 and bread has price index 140- eggs are not more expensive than bread, their price has just risen more than the price of bread from a particular point in time

Coverage

• For practicality, CPI only measures price changes in items in metro Lipan areas of 8 capital cities where around 2/3 of households live

• doesn’t measure price changes in regional/rural/remote areas. - doesn’t consider differences in spending patterns between individual households e.g. car has 3 percent weight but some households don’t have a car.

Quality changes

• pure price changes calculated- so it should ignore price changes from quality variations/ new products e.g. smaller bag of pasta, higher quality phone with better camera

• ABS attempts removing price changes from quality changes or mix of items bought by households- calculate prices assuming that weight of pasta stayed the same, estimate price impact of improved camera and adjust mobile phone camera price.

• only estimation, limited information→ under or overestimation of the pure price changes

• services- more difficult to quality adjust- changes occur slowly, hard to measure improvement so quality partly accounted/ not accounted.

• e.g. better x-ray technology at a hospital could better detect injuries, but it is difficult to calculate how much the improvement in detecting injuries is worth.

Substitution bias

CPI assumes a fixed basket, but households switch to cheaper alternatives when relative prices change. This makes CPI overstate inflation (substitution bias), because expensive items stay “overweighted” and cheaper items “underweighted.” Updating the weights more often reduces this bias.

New products

CPI doesn’t immediately include new goods or services; a product is only added once it’s widely available and has significant market share (e.g., smartphones in the early 2000s), which can temporarily understate changes in the cost of living.

Cost of living

• CPI isn’t ideal because it measures price changes, not the change in household spending required to maintain a given standard of living.

• The ABS publishes other indexes, like Living Cost Indexes (LCIs), which aim to provide a better indicator of cost of living for different households.

Headline inflation

• Measured by the Consumer Price Index (CPI).

• Headline CPI is the official target (2-3 %)

• The CPI measures quarterly changes in the price of a fixed 'basket' of goods and services that account for a large proportion of expenditure by metropolitan (capital city) households.

• Published quarterly by the Australian Bureau of Statistics (ABS).

• It is the figure reported by the media and provides a broad measure of household cost of living changes.

Underlying inflation

• The headline CPI can be misleading due to volatile and seasonal items (e.g. fruit, vegetables, petrol).

• Underlying inflation is preferred to headline CPI as it excludes or adjusts for volatile items (e.g. fruit, vegetables, petrol) whose price changes are often temporary and unrelated to broader economic conditions, making it a clearer and more reliable indicator of inflationary trends, so it’s preferred by economists

• The Reserve Bank of Australia (RBA) focuses on underlying measures when deciding monetary policy, as these reflect broader and more persistent inflationary pressures.

Role of underlying inflation in policy making.

• Headline CPI is the official inflation target (2–3% over the medium term).

• However, underlying measures strip out temporary and irregular influences, allowing policymakers to judge whether price changes are due to:

  • Temporary factors

  • (e.g. infrequent tax regulation changes like the introduction of GST in 2000 which caused the price of many items to increase- RBA responded by showing headline CPI inflation excluding these tax changes)

  • (e.g. supply chain disruptions because of weather shocks-Tropical Cyclone Larry in 2006 destroyed banana crops, causing a 400% price spike- CPI excluding volatile items shows the underlying inflation adjusted for this volatile event)

  • Or a broad-based shift in inflation, which may require the RBA to adjust the cash rate.

Methods of measuring underlying inflation

1. CPI excluding volatile items

2. Trimmed mean

3. Weighted median

CPI excluding volatile items

• Removes fruit, vegetables, and fuel.

• These are excluded because they are highly volatile due to:

  • Weather events (e.g. Tropical Cyclone Larry in 2006 destroyed banana crops, causing a 400% price spike).

  • Global oil price and exchange rate movements/ currency valuation changes affecting petrol prices.

• Always removes the same categories.

Trimmed mean

• All CPI items are ordered from largest to smallest price changes.

• The top 15% and bottom 15% of price changes are ‘trimmed away’.

• The remaining 70% is averaged, giving a measure less affected by extreme movements.

Weighted median

• all items ordered by their quarterly, seasonally adjusted price change

• the inflation rate of the item at the middle of the price changes in the CPI basket (the 50th percentile by weight)

• In other words, it is the inflation rate of the ‘middle’ item when ranked by size of price change.

Inflation graphs!!!!!!

real GDP on x axis, price level on y axis

Demand pull inflation

• 'too much money chasing too few goods'.

• Results from high levels of demand caused by high levels of aggregate expenditure. Suggesting an excess demand for the resources available at the time.

• AD shifts right, new equilibrium at higher price and greater Real GDP (output)

Indicators of demand-pull inflation

• High levels of spending on construction and consumer durables such as furniture and white goods, generally associated with the late upswing and boom periods of the business cycle

• Excess demand for labor in certain sectors of economy→ relative shortage of workers→ price of wages go up

• excess demand for limited resources- increased competition, increased price

• some industries more affected than others (booms→ rising prices in building sector)

• Excess money supply

  • economy initially at equilibrium

  • when the rate of growth of money supply is exceeds the rate of growth of real output, aggregate demand rises faster than the economy’s productive capacity. With resources fully employed, output can’t expand in the short run to meet the rising demand, creating upward pressure on the general price level.

  • Shifts equilibrium to a higher price level rather than higher output.

Excess money supply graph

• Initial Equilibrium:

  • The economy starts at full employment, where Aggregate Demand (AD₁) intersects Aggregate Supply (AS) at output level Yf and price level P₁.

• Increase in Money Supply:

  • When the money supply grows faster than real output, households and firms have more spending power.

  • This increases aggregate demand, shifting the curve rightward from AD₁ to AD₂.

• Excess Demand:

  • At full employment output (Yf), the economy cannot produce much more in the short run.

  • The excess demand puts upward pressure on prices.

• New Equilibrium:

  • The economy moves to a higher price level P₂ while real output remains close to Yf.

  • The rise in prices reflects demand-pull inflation.

Cost push inflation

• rising production costs are passed on to consumers, who pay higher prices for final goods and services.

• caused by increases in the prices of significant productive inputs:

• if wages increase faster than worker productivity

• if the prices of imports rise, perhaps as a result of depreciation of the domestic currency

• if oil prices rise - oil being a significant cost component in production and distribution

• if household energy prices rise

• AS shifts left, equilibrium at higher price level, lower real GDP (output)

Distinguishing cost push and demand pull inflation

• difficult to distinguish demand pull and cost push instances of inflation.

• e.g. a wage rise will increase the cost of supply for business firms, but it will also increase the income of households, and enable them to purchase more goods and services.