Topic 3 Ch 9 Inflation

negative effects of inflation

economic growth and uncertainty, wages, income distribution, unemployment, International competitiveness, Exchange rate impacts (purchasing power parity), Interest rates

cause: cost-push inflation

occurs when there is an increase in production costs (such as oil prince increases, or wage increases) that producers pass on in the form of higher prices thus raising the rate of inflation. sources of cost push inflation include wage rises in excess productivity, profit margin increases, import costs rise, increases in taxes and charges and price of raw materials.

what microeconomic policies used to reduce inflation

reduced protection, reforms to labour market, greater investment in economic infastructure

How is pre-emptive monetary policy used to reduce inflation

- The RBA has used pre-emptive monetary policy by talking action against inflation before it emerges as a problem. For example the rba increased interest rates seven times in 2009 and 2010 to address concerns about inflation after the economy emerged from the downturn by the GFC. The RBA generally aims to increase interest rates before inflation reaches the top of the target band to account for the time lag between policy implementation and effect

inflation rate formula

CPI (current) - CPI (previous) / CPI(previous) x 100

How is fiscal policy used to reduce inflation

In a period of high inflationary pressures the government might increase revenue and reduce spending to minimise demand pressures in the economy and therefore reduce demand-pull inflation. Fiscal policy settings that support low-inflation objective may also reduce the need for higher interest rates to combat an inflation challenge. However with low inflation in recent years fiscal policy has not been influenced by concerns about inflationary pressures

CPI definition

summarises the movement in the prices of a basket of goods and services weighted according to their significance for the average Australia household

defintion of inflation

the sustained increase in the general level of prices in an economy

1 statistic government restrictions causing inflation (cost-push)

tobacco excise increase of 12.5% from 2013-20 made tobacco the largest single contributor to headline inflation in this period

2 statistics Imported inflation

1. Depreciation of $A between 2015-19 increased imported inflation from 1.5% in 2015 to 2% in 2019 2. In 1973/75 and 79/80 imported inflation rose due to rising oil prices and OPEC restrictions

2 Statistic on demand-pull inflation

1. During the mining boom investment spending by the mining sector increased from 2 per cent of GDP to 8 per cent, boosted aggregate demand and caused upward pressures on prices with the inflation peak of 4.44% in 2008 2. For example following increased government subsidies for childcare in Australia in September 2020, the return to full-priced childcare boosted quarter average CPI.

explain two negative effects of inflation

1. High inflation increases price of Australia's exports, reducing international competitiveness and export quantity. By increasing the price of domestic goods, consumers switch to import substitutes, worsening the trade deficit. 2. During periods of higher inflation, employees will seek larger wage increases in order to be compensated for the erosion of purchasing power of their nominal wages. This can lead to the emergence of a wage-price inflationary spiral where wage increases lead to higher prices, which lead to higher wage demands and so on.

2 statistics on negative effects of inflation (Economic growth and discouraging investment)

1. In 1990 the inflation rate in 1990 was 7.48% which distorted economic decisions with consumers excessively spending to avoid further erosion of their purchasing power and consequently, the collapse saw a year long recession in Australia 2. Prior to the GFC there was high levels of investment due to low inflation

how is reduced protection sued to reduce inflation (microeconomic policies)

1. Reduced protection has lowered prices of imports and increased the competition faced by domestic producers from both overseas competitors and new entrants to domestic markets. This makes it more difficult for domestic producers to raise prices. A significant lowering in protection seen by 35% decrease in the average tariff level from 1968 to present has increased competition face by domestic consumers and decreased prices of imports therefore helped push relative prices down.

4 benefits of low inflation

1. Small amounts of inflation may encourage consumer expenditure and cause large purchases to be brought forward in order to minimise the negative effects of inflation. This increases aggregate demand and causes economic growth. 2. Similarly, small levels of inflation decrease the risk of deflation occurring which has the potential to cause recession. 3. Speculators will also benefit from asset price inflation if they sell before the boom collapses. 4. Employees with good bargaining power whose labour skills are in short supply should be able to gain wage raises greater than the inflation rate

3 cost-push inflation stats

1. Wages make up an average of 60% of a firm's costs 2. Recently, in October 2021 the sharp increase in petrol prices is one factor contributing to the headline rate of inflation at 3.0% however wage growth has been slow meaning that the underlying inflation is within the Reserve Bank's longer-term average target range of 2% to 3% for the first time since 2015. 3. Introduction of GST in 2000 led to the highest headline rate of inflation (6.1% in june 2001).

statistic on unemployment and inflation

1970s - Australia experienced simultaneous increased inflation and unemployment - stagflation: inflation rate and unemployment rate rise simultaneously. For most of the 1990s and 2000s , Australia experienced the opposite - a combination of low inflation and falling unemployment.

stat on effects income distribution (labour paragraph)

After the GFC when inflation dropped to 1.77% from its peak at 4.35% income inequality improved as the lovest quintile increased from 7.3% to 7.4% and the highest quintile dropped from 41% to 40.2%.

stat on monetary policy to address inflation

After the economic downturn caused during the GFC, the RBA increased the cash rate 7 times to pre-emptively address inflationary concerns during the economic recovery.

explanation of demand-pull inflation graph

Aggregate demand shifts from AD1 to AD2 as consumers force up prices by bidding against each other for the limited goods and services. Prices will therefore increase from P1 to P2 causing an extension in supply. The high levels of aggregate demand can come from any combination of components of aggregate demand

explanation of cost-push inflation graph

As aggregate supply shifts from AS1 to AS2, producers face higher costs, so they supply less quantity for any given price level. Prices therefore increase from P1 to P2 causing a contraction in demand

stat on effects wage growth (labour paragraph)

Australia has avoided a wage spiral since the 1980s and in more recent years the opposite has occurred as annual wage growth has only averaged 2%.

general statistic on inflation

Australia has sustained relatively low levels of inflation since the early 1990s, with head line and underlying inflation averaging 2.4% and 2.6% respectively between 1996 and 2020

stat stagflation (labour paragraph)

During the mid 1970s, one of Australia's main economic issues was stagflation; as unemployment rose to around 9% and inflation rose simultaneously peaking at 15.4% in 1974

stat on fiscal policy to address inflation

For example, the $213bn of fiscal stimulus response to COVID-19 has been effective in slowly increasing the rate of inflation in economic recovery. Consumer prices rose 0.8 per cent in the three months to September and 3 per cent over the past year. However in October 2021 with the surprisingly strong core inflation at 2.1 per cent has meant that the central bank may be forced to start winding back its COVID-era stimulus.

How does infrastructure investment help reduce inflation and example (microeconomic policy)

Greater investment in economic infrastructure such as roads, railroads and ports can help avoid transport and other bottlenecks that can increase production costs and add to inflationary pressures. For example governments have invested $123 billion in infrastructure gaps since 2015 and with a committed forward pipeline of over $200 billion

how does inflation cause a negative effect of income distribution

High inflation rates negatively impact distribution of income because lower-income earners find income not rising as quickly as prices. Lower-income earners face higher interest rates on borrowings if inflation rises. High rates of inflation hurt those individuals who are on fixed incomes or whose incomes are not indexed to (or rise as fast as) the rate of inflation.

How does unemployment have a negative effect on interest rates

Higher inflation usually results in higher interest rates as central banks try to reduce demand pressures in the economy and avoid the negative consequences of high inflation.

cause/ type: inflationary expectations

If individuals in the economy expect higher inflation in the future, they may act in a way that causes an increase in inflation. This can happen in two ways. If the prices of goods and services are expected to increase in the economy, consumers purchase products before price increase. Or If employees expect inflation to increase, they will take this into account when negotiating their wage increases and the higher wage increases may be passed on by firms, leading to cost-push inflation.e.g. 1990s recession. More recently, inflationary expectations have been subdued due to persistently low wage growth

how does inflation cause a negative impact on exchange rates (short term and long term)

In the short term higher inflation appreciates the exchange rate as speculators expect the RBA to increase interest rates in response, which attracts greater financial flows, leading to an appreciation. However over time high inflation generally causes a currency depreciation. This is because it leads to a lack of international competitiveness and therefore, decreased export demand causing $A depreciation. Furthermore, the economic theory of purchasing power parity says that exchange rates in the long run will change to reflect the real purchasing power of currencies. This means economies with high inflation should experience a depreciation relative to those economies with lower inflation rates.

How does inflation have a negative consequence on unemployment

Inflation can cause unemployment in two ways. 1. In periods of high inflation businesses react to higher costs/excess demand by reducing workforce, increasing unemployment. 2. Higher inflation results in more contractionary fiscal and monetary policies which can mean slower economic growth leading to higher unemployment in short to medium term. However more generally in the short term periods with high levels of unemployment have low inflation rates & low unemployment levels have rising inflation. The relationship between inflation and unemployment is demonstrated by Phillips curve which shows the trade-off governments face in trying to simultaneously achieve economic objectives of low inflation and low unemployment. In the long term this inverse relationship breaks down.

head line inflation

The quarterly rate of change in CPI is called the headline rate of inflation. Headline inflation is the measure of total inflation within an economy, including commodities of food and energy prices which tend to be more volatile and prone to inflationary spikes.

RECENT STATS on monetary policy to address inflation

The very low levels of inflation only 0.87% in 2020, meant that the RBA was "committed to maintaining highly supportive monetary conditions" and providing forward guidance that it would " not increase the cash rate until actual inflation is sustainably within the 2-3% target range" and due to low interest rates near zero, there was little more monetary policy can do to support inflation growth. However in 2021 Australia's inflation rate bounced back and The Consumer Price Index (CPI) rose by 0.8% in the 3 months to September and 3% over the past year meaning that the central bank may be forced to increase interest rates to pre-emptively stop too much inflation. Furthermore the RBA's decision to abandon the yield curve control, no longer targeting the April 2024 bond yield at 0.10%, was due to the "earlier-than-expected progress towards the inflation target" (2 to 3 per cent).

cause/type: imported inflation

Transferred through international transactions (rising import prices) and depends on market conditions. An increase in the price of imported goods will increase the inflation rate. in exactly the same way as an increase in the price of domestically produced goods. Any depreciation in the $A means that importers have to pay more, these price increases eventually filter through to the CPI after increased costs are passed along to consumers. E.g. the depreciation of the $A between 2015 and 2019 increased imported inflationary pressures, particularly in the retail industry.

underlying inflation

Underlying inflation removes one-off or volatile price movements and is measured by an average of the trimmed mean inflation and weighted median inflation

Causes of inflation Demand pull

When aggregate demand exceeds the productive capacity of the economy, price rise as output cannot expand any further in the short term. Consumers force up prices by bidding against each other for the limited goods and services avaliable. Consumers are willing to pay a higher price for any given level of supply and price increase.

How are reforms to the labour market reducing inflation and exmaple (microeconomic policy)

addition reforms to the labour market attempt to ensure that wage increases are linked with productivity improvements. If productivity rises the economy will be able to afford real wage increases without inflationary pressures. Wage growth has since been low averaging 2.3% p.a. which has been effective in managing cost-push inflation. During the mining boom of the 2000s and 2010s Australia's deregulated labour market allowed for wage increases for workers whose skills were in high demand without leading to large wage rises in other sectors in the economy, this helped to restrain inflationary pressures

cause: excessive increases in the money supply

an increase in the money supply can outstrip the growth rate of the economy, an increased volume of money pursues the same amount of goods and services known as 'monetary inflation'. Increasing money supply without increasing real production causes inflation.

1 Statistics Inflationary expectations

currently in Australia with consumers expecting housing prices with NAB has predicting Sydney's house prices will rise by 17.5 per cent over 2021, causing an increase in current demand before prices rise contributing to a housing bubble and inflation in the industry

How is Monetary economic policy used to sustain low inflation

it attempts to sustain economic growth at a level that does not create inflationary pressures, trying to hold inflation between the RBA's 2-3% target. If inflation starts rising, the RBA is able to increase interest rates throughout the economy by tightening monetary policy. This has the effect of dampening consumer and investment spending, resulting in a lower level of economic activity and therefore lower inflation