LECTURE 4: INFLATION

4.1 INFLATION OVERVIEW:

WHAT IS INFLATION?
 inflation is the general increase in price level over time
 with positive inflation, the value of money decreases over time

INFLATION IN AUS & OTHER COUNTRIES:

 In AUS, prices tend to increase very gradually over time
 In some other countries, inflation has been very high  meaning that prices increase very quickly
from year to year

CASE STUDY: Venezuela

 Venezuela started a socialism experiment called “the Bolivarian revolution” in 1999 after Hugo
Chavez was elected as the president

 the experiment was an economic disaster  the country has been suffering from recession,
food shortage & very high inflation

 Venezuela’s inflation was estimated to be over 250% in 2016 & somewhere b/w 1000%-
2000% in 2017

when inflation is very high it’s

called hyperinflation

MONITORING INFLATION:
 countries tend to monitor inflation very closely
 have timely & accurate inflation figure is so important that in June 2018, the ABS asked the
Federal Gov., for $4M funding so that it can more accurately measure inflation is AUS

high inflation can lead to

economic uncertainty & harm
long-term economic growth
4.2 MEASURING INFLATION:
MEASURING INFLATION:
 price lvl. measures the average prices of GAS in the economy
 inflation rate: is the % change in the price level from 1 period to the next
 to measure inflation, we must first measure the price level

example:
if the price level increased from $45 in 2018 & $50 in 2019…

$ 50−$ 45
inflation rate= ×100 ¿ 11.1 %
$ 45
2 WAYS TO MEASURE PRICE LEVEL:
1. consumer price index (CPI)
2. GDP deflator

CONSUMER PRICE INDEX (CPI):

 CPI is a measure of changes in the retail prices of a basket of goods & services

BASKET OF GOODS & SERVICES

 representative of consumption expenditure by a typical Australian household of 4
living in a capital city  that’s why CPI is also known as the cost of living index

1. each quarter, the ABS gathers info. on prices of those GAS in the
basket

Items that are consumed

more are weighted more
e.g. heavily housing is the largest expenditure item accounting for
over 20% of typical household’s budget, followed by food &
non-alcoholic drink

2. using this info. the ABS can construct the CPI

3. then they use the change of the CPI to measure inflation

LIMITATIONS OF USING CPI TO MEASURE

INFLATION:
4 BIASES IN CPI CALCULATIONS:
1. substitution bias: occurs because the CPI assumes that people consume the same amount of a G
or S even if there’s a change in its price

 realistically, when price of 1 good ↑, consumers will substitute this good w/ another

2. increase in quality bias: some G & S may have become more expensive because their quality has
improved

e.g. your current smartphone may cost a lot more than a Nokia, but it has many more features

 the ABS uses a number of methods to adjust for quality changes

3. new product bias: the ABS only update the content of its CPI basket every 5-6 yrs  new
products introduced during that period won’t be accounted for in the CPI

 the prices of these products tend to drop overtime, especially tech. products but the CPI does NOT
reflect that

4. outlet bias: the ABS only collects data from traditional retail stores  this is especially relevant
when considering the rise of online shopping

 purchases from online or discount stores are NOT accounted for consumers might ∴ actually be
paying less than is recorded
 MORE LIMITATIONS:
1. cost of living: CPI is often used to measure changes in the cost of living, but it is not an ideal
indicator of this

 while the CPI measures price changes, cost-of- living inflation is the change in spending by
households required to maintain a given standard of living.

2. CPI is not an indicator of the price level: CPI measures the rate of price changes in the economy,
but NOT the price level.

- example: if the price index of bread is 140 and the price index of eggs is 180, it doesn’t mean
that eggs are more expensive than bread

 it means that the price of eggs has increased by more than the price of bread from a
particular point in time.

3. coverage: for practical reasons, the CPI measures price changes of items in the metropolitan
areas of AUS’s 8 capital cities

 It does NOT measure price changes in regional, rural or remote areas

 CPI also does not take into account the differences in spending patterns between individual
households

 i consumers purchase fewer of those products that increase most in price & more of those
products that increase less in prices compared to the CPI basket, then changes in the CPI
overstate the true inflation rate

WHY?
 as prices of some GAS increase relative to others, consumers tend to buy fewer of them & more
of others. However, the CPI assumes that consumers purchase the same amount of each product
throughout time (until the next adjustment of the CPI basket)

∴ the prices of the market basket that consumers that consumers actually buy rise less than the prices
of CPI basket
 CPI overstates the true inflation rate

4.3 CALCULATING INFLATION:

3 KEY STEPS TO
CALCULATE
INFLATION:
 - Cost of goods in both current &
base year

- It’s a ratio
- no units

- I

example:
 quantity is constant
 2018 is base yr in this
example
 CPI in 2019 tells us the
relative cost of living to that
in the base year

( 2.1120
( 2 ×40 )+ ( 1.5× 60 ) + ( 1.2× )+ ( 1.6×
×40)=$ 314 60 ) + ( 1.5 ×120 )=$ 360

CPI= ( 314
314 ) ( 314 )
×100=100CPI= 360 ×100=114.65

inflation rate=( )×100=14.65 %

114.65−100
100

KEY POINTS:
 any year can be chosen as the base year
 the base year doesn’t have to be the first year in your data set
 changing the base year will typically change the CPI figure
 but the inflation rate will stay the same no matter what yr you choose
 CPI in base yr will always = 100

CALCULATING % CHANGE IN CPI OVER A RANGE OF

YEARS:
example: the average annual inflation rate b/w 2005 to 2015
FORMULA: COMPOUND ANNUAL GROWTH RATE
(CAGR):

4.4. NOMINAL & REAL VARIABLE

CONSIDER THIS:
 A study by the National Center for Social & Economic Modelling, in 2014, showed that 1.8M
 Australians will be forced into higher tax brackets b/w 2014 to 2018 due to bracket creep

BRACKET CREEP
- is when an increase in nominal income
pushes people into higher tax brackets
  Your nominal income tends to rise w/ price level over time  but often, the tax brackets stay
the same
 By some calculations, an average AUS worker reportedly pay $3,800 more tax every yr due
to bracket creep

- if tax brackets are specified base on real income instead of nominal income then the
bracket creep problem wouldn’t exist

NOMINAL VS REAL VARIABLES:

 Nominal variables: are NOT adjusted for inflation
these adjustments are important
 Real variables: are adjusted for inflation

PURCHASING POWER:
 purchasing power refers to the amount of goods or services that a certain amount of money
can buy

 can be an indicator of the current market condition.

DETERMINING IF OUR PURCHASING POWER HAS ↑OR

↓OVER TIME:

 To do this, we must consider the real wage NOT nominal wage

REAL INCOME:
 a higher real income means a higher purchasing power since real income refers to
the income adjusted for inflation

NOMINAL VS REAL INTEREST RATES:

r , i, π are expressed as decimals NOT %

r , i , π are expressed as decimals∨%

FISHER EQUATION:
 allows us to work out to what extent our investment grows faster than inflation, such that our
wealth is growing in real value over time

REAL INTEREST RATES:

 express the true cost to borrowers & the true return to lenders before tax

 if the actual inflation differs from the expected inflation, then the true cost & return will be
different from the expected cost & return

EFFECTS OF UNEXPECTED INFLATION:

example:

 Suppose Kate agrees to lend Amy some money for a year at a nominal interest rate of 5%
 Both of them expect that the inflation rate of the coming yr to be 3%. However, one year later
when Amy repays the debt with the full interests, the price lvl. has only gone up to 2% instead
of 3%  inflation is unexpectedly lower

since the actual return of

lending is higher than
expected  the lender gains

since the actual real cost of

borrowing is higher than
expected  the borrower
loses

INFLATION LOWER THAN EXPECTED:

Lenders will gain
Borrowers will lose

INFLATION HIGHER THAN EXPECTED:

Lenders will lose
Borrowers will gain

∴ when inflation differs from its expected value there will be a redistribution of wealth b/w lenders &
borrowers

IMPLICATIONS OF WEALTH BEING REDISTRIBUTED:

1. If inflation is volatile it will become more difficult for us to predict the actual real returns to
lending & the actual real costs of borrowing
  as a result, high inflation volatility & uncertainty could be harmful to saving & investment & ∴
long-term economic growth

2. Suppose a gov. has policy tools to manipulate inflation, if the gov happens to have large
public debt  it may have incentive to raise inflation about the expected level to reduce its
real cost of borrowing

4.5 CAUSES OF INFLATION

AGGREGATE DEMAND:
 total demand by all sectors for G&S produced by the economy is  AD

AGGREGATE SUPPLY:
 total amount of G&S our economy produced is  AS

INTERACTION B/W AD & AS:

 interaction of AD & AS determines the equilibrium price level & output
 this interaction is very similar to the standard supply & demand

CAUSES OF INFLATION: AD
 if AD is hit by +ve shocks  equilibrium price will ↑  inflation
 inflation caused by +ve AD shocks  demand-pull inflation

DEMAND-PULL INFLATION:
 increase transfer payment (e.g. gov. faces high chance of being defeated in the next election)
 AD increases
 If the economy is already producing close to its full capacity, AS cannot keep up with higher
AD
 Too much money chasing too few goods
 Sellers can afford to raise their prices
  inflation

CAUSES OF INFLATION: AS
 if AS is hit by -ve shocks  equilibrium price will ↑ inflation
 inflation caused by -ve AS shocks  cost-push inflation

COST-PUSH INFLATION:
Example: a country needs to import oil for energy
 if world oil prices go up  costs of production increase
 producers pass higher production costs onto consumers
  increase in labour costs that exceeds productivity growth or higher costs of raw materials 
similar effects on AS
  inflation

PRICE-WAGE SPIRAL:
 Where demand-pull inflation leads to cost-push inflation
 Demand-pull inflation first raises the price lvl.  lowers real wage for workers
 Workers bargain for higher nominal wages to compensate for inflation  this will lead to
higher production costs & ∴ cost-push inflation

QUESTION:

4.6 HYPERINFLATION, DISINFLATION &

DEFLATION:
HYPERINFLATION:
 Inflation is very high  hyperinflation
 Some people consider by 50% or more per month  it can be considered hyperinflation
 too much money chasing too few goods  inflation
 caused by huge excess supply of money

CASE STUDY:
The world record for hyperinflation is held by Hungary at the end of World War II: 41.9 quadrillion %
per month or 4.19 × 1016%
 If workers received wages at 9 am & didn’t spend them immediately  their purchasing
power dropped by ½ by mid-night!

DEFLATION:
 Negative inflation  a general decrease in prices of GAS
e.g. if inflation = -2% v deflation

DISINFLATION:
 Decline in the inflation rate
e.g. if inflation declines from 10% to 3%  disinflation
EXAMPLE:
Japan’s disinflation & deflation

WHY IS DEFLATION BAD?

 If consumers expect prices to continue to fall (they have a deflationary mindset) delay
consumption
 this will weaken AD  businesses cut prices  scale back production  lay off workers
 once unemployment ↑, households cautious about spending  vicious cycle of weaker
demand & falling prices
 falling prices  real debt of companies to ↑ , less new investment  drag down AD & add to
deflationary momentum

QUESTIONS: