macro lec 02 (inflation, interest rates, savings)

Three Goals of RBA

Three Goals of RBA (ultimately maintaining purchasing power for the country)

1. stability of the currency

2. maintenance of full employment (inverse relationship bet employment & inflation)

3. the economic prosperity and welfare of the people of Australia

CPI Definition

measures the cost of purchasing a specified basket of goods and services relative to a base year (conducted by ABS) (aka measuring price levels)

• Requires collecting data on prices over time

• Requires collecting data on household expenditure to select a reasonable basket of goods and services

• In Australia, collected on a quarterly basis

When looking a whole (aggregate) for country:
Price: becomes CPI
Quantity: becomes GDP

Calculating CPI

CPI=Pt/P0
Pt= period t, P0= base period

Find sum of price at base year quantities

Calculating CPI Index

Calculating Inflation Rate

(1+__)^(of periods) x 100

ANNUAL INFLATION EXAMPLE:
e.g. (1+0.4)^4 × 100

Biases in Measuring Inflation

• Substitution Bias: Composition of goods changes over time, typically away from goods that are becoming relatively more expensive

• Quality Bias: Difficult in measuring product quality

Costs of Inflation (negatives to rising inflation)

Likely to be small for low inflation but can be substantial for larger rates of inflation

• Reduced real income

  • If CPI is increasing 2%, but wages increase 1.5% can't keep up with inflation 

• Redistribution wealth

  • Loans often nominal (e.g. HECS)

• Bracket creep

  • If progressive taxing, rich pay more tax (but if opposite then bracket creep

• Menu costs

  • Costs incurred when changing prices and planning

• Noise in price system

  • Resource allocation not knowing if buying for best value if prices keep changing

Nominal vs Real Interest Rate Definitions

• Nominal: e.g. quoted by banks or loans does not account for inflation

• Real: inflation-adjusted (therefore change price level from period t to t+1

  • nominal=official, real=decision making

Calculating Real Interest Rates

Fischer Equation

Expected Real Interest Rate

Household Consumption and Saving

After-tax income (disposable income) an individual earns can be either used for

• Current consumption

• Saved for future use - future consumption or bequest

• Consumption and saving are connected

Wealth: an individual’s assets (financial and real) less an individual’s liabilities

• Saving adds to an individual’s wealth

• Wealth has an impact upon economic decisions

• Stock versus flow distinction

Reasons of Saving (cycle of saving)

Incentives:

• Lifecycle saving - borrow money when income is low and save money when income is relatively high

• Precautionary saving - saving for unexpected events

• Bequest saving - for saving for the next generation

Determinants:

• Real interest rates: opportunity cost

• Demographics - the age structure is important

• Beliefs about future events

• Behavioural economics: temptation and self-control

Equations for National Savings in Open and Closed Economy

Forms of National Saving

• Firms - revenue less wages, other costs and dividends

• Government - taxation revenue less expenditure

Determinants of Investment

Standard assumption: firms base investment decisions to maximise profits or a cost-benefit  analysis

• Capital is costly to acquire - firms must pay an interest rate, r plus depreciation cost, δ for  using capital

• But more capital stock increases output, y = F(k)

• Assume output is sold at a fixed price p

Market for Loanable Funds (how we attain what is needed to invest)

There are some individuals in the economy that wish to save, and some to invest

• Interest rate is essentially the price associated with savings and investment to ensure  market equilibrium

• Individuals increase saving as the real interest rate rises

• Firms reduce investment as the real interest rate rises

Investment and Capital Stock

Profit Maximisation

Marginal Product of Capital

Extra Questions