Macroeconomics - Unit 2: Inflation

Review from Last Week

• Business Cycle: Depicts the rise and fall in output (production of goods and services) over time.
• Four Phases of the Business Cycle:
  • Expansion
  • Peak
  • Contraction
  • Trough

Economic Expansion

• Definition: The upswing of the business cycle towards a peak.
• Characteristics:
  • Increase in production/output
  • Decrease in unemployment
  • Increase in wages
  • Increase in consumer spending

Economic Contraction

• Definition: The downswing of the business cycle towards a trough.
• Characteristics:
  • Decrease in production/output
  • Increase in unemployment
  • Decrease in wages
  • Decrease in consumer spending

Inflation and the Business Cycle

• During Expansion: Increased consumer demand leads businesses to increase output until they reach their productive capacity, leading to prices being pulled up due to higher demand than available output.
• During Contraction: Decreased consumer demand leads businesses to decrease output, potentially lowering prices or offering discounts, decreasing inflation or causing deflation.
• The business cycle's GDP is higher with low unemployment and lower with high unemployment.

Inflation

• Definition: The increase in the general level of prices of goods and services over time.
• Inflation Rate: The percentage change in the price level from one year to the next.

What is Inflation?

• Inflation is an increase in the prices of goods and services that households buy, measured as the rate of change of those prices.
• Prices typically rise over time, but can also fall (deflation).
• Example: A bag of lollies costing $0.20 in the past might cost $2.00 today.

Why is Inflation Important?

• It is important for the rate of inflation in an economy to be managed; a low, steady rate of inflation is good for the economy.
• If inflation is too high, the currency loses its value.
• Hyperinflation: When inflation increases at a very rapid rate.
  • Example 1: In early 1920s Germany, inflation reached rates of more than 30,000% per month, with prices doubling every few days.
  • Example 2: In 2019, inflation in Venezuela reached 1 million percent.

Measurement of Inflation

• Consumer Price Index (CPI): Measures the average prices of goods and services that a typical consumer buys (basket of goods and services).
• Sometimes called the ‘cost of living index’.

The “Basket”

• 87 different classes of spending.
• About 100,000 individual prices every quarter (3 months).
• Across 8 capital cities of Australia.
• The basket is reviewed every 6 years to ensure it reflects Australia’s buying habits.

How is Inflation Measured?

• The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the changes in the price of a typical basket of goods and services consumed by households. The inflation rate is the percentage change in the price of this basket over time.
• If the inflation rate is 3%, a 'basket' of goods and services that cost you $100 last year will cost you $103 this year.
• Groups in the CPI basket and their weights:
  • Housing - 23%
  • Food and non-alcoholic beverages - 16%
  • Recreation and culture - 13%
  • Transport - 10%
  • Furnishings, household equipment, and services - 9%
  • Alcohol and tobacco - 7%
  • Insurance and financial services - 6%
  • Health - 5%
  • Education - 4%
  • Clothing and Footwear - 4%
  • Communication - 3%

Consumer Price Index

• Measured every 3 months or quarter.
• The annual rate of inflation is the percentage change in the CPI from one year to the next.
• Compares prices against a Base Year.

The CPI: A Simplified Calculation

CPI = \frac{$231}{$210} \times 100 = 110

Calculating The Inflation Rate

\frac{CP1{year (x)} – CPI{year (x-1)}}{CP1_{year (x-1)}} \times 100 = \frac{110 – 100}{100} \times 100 = 10%

Causes of Inflation

• Demand Pull
• Cost Push
• Imported

Demand Pull Inflation

• Excess demand compared to supply causes shortages and prices rise.

Possible Causes of Demand Pull Inflation

• High levels of consumer spending.
• Increases in money supply – easy credit (loans)/ low interest rates can lead to excessive borrowing and spending.
• Governments ‘printing money’ to finance their overspending (budget deficits).

Cost Push Inflation

• Increased production costs cause firms to raise prices to cover the costs.
  • e.g. Increase in price of oil, raw materials
  • ‘Supply shocks’ – floods, cyclones can increase food prices
  • Wage increases
  • Increases in sales taxes

Imported Inflation

• Increased prices of imported inputs in the production process – e.g. oil, can increase input costs and force up prices of final goods and services.
• Increased prices of imported consumer goods and services will feed into higher price levels, as they are included in the CPI basket.

The Effects of Inflation

• Cost of living rises.
• Consumers’ purchasing power reduced.
• Redistribution of wealth
  • Fixed income earners, lenders lose as the value of money decreases.
  • Borrowers, asset holders gain.
• Interest rates may rise (compensation).
• International competitiveness falls as export prices rise.
• Planning uncertainties for business.
• Resources diverted from production to assets and speculation.
• Investment, employment, and growth may fall.

Inflation Targets

• Zero (0%) inflation may be impossible.
• In Australia, the Central Bank’s (Reserve Bank of Australia) target is to contain inflation to an average of 2 – 3% annually.

Inflationary Expectations

• Refers to the mood of households and firms.
• If they expect that inflation will continue, they may take action that actually causes price rises.
  • Consumers, firms bring forward their spending – will increase demand pressure.
  • Workers may seek higher wages – costs increase.

Deflation

• A decrease in the general price level of goods and services in the economy.
• What is wrong with deflation?
  • Consumers delay purchases – reduces demand.
  • Could indicate that the economy is contracting – job losses.
  • Assets decline in value.
  • Wages may fall.
  • Debtors lose.