Inflation

Target Rate: 2-3%

Definition: Persistent and appreciable rise in the general or average level of prices over time

Measured by Consumer Price Index (CPI): Weighted index based on proportion of income spent on particular items

• Measures changes in the price of a basket of goods and services bought by households from 1 quarter to the next

CPI

CPI attaches weight to each commodity to reflect importance in pattern of expenditure in an average household

Weights change depending on preference or reaction to changes in price

Inflation Rate Calculation:

\[\frac{CPI_{yr2}\space - CPI_{yr1}}{CPI_{yr1}}*100\]

Headline and Underlying CPI Measures

Headline Measure (CPI): Measure that is reported by the media

Underlying Measure: Inflation that best reflects market forces

• Trimmed Mean: Removes the most volatile 15% of items from each side of the CPI
• Weighted Median: Change in the middle 50th percentile by weight
• CPI Excluding Volatile Items: Which is the average inflation rate of all items in the CPI basket except for fruit, vegetables and fuel are usually very volatile because they are often affected by supply disruption, such as unusual weather, or changes in how much oil is supplied to the world market. The CPI excluding volatile items always removes the same items.

Limitations of CPI

• Only reports price movements in metro areas
• Does not account for quality of goods and services (it only looks at the price)
• Not regarded as “true” cost of living index: does not reflect changing consumer preferences or substitutes that consumers make daily

Types of Inflation

Demand Pull Inflation

• Excess of aggregate demand over aggregate supply at the full employment level of output and is caused by an increase in aggregate demand.
• Rise in the general price level resulting from an excess of demand over supply
• “Too much money chasing too few goods”
• Will also push wage prices up with higher demand for labour

Cost Push Inflation

• Caused by a fall in aggregate supply, in turn resulting from increase in wages or prices of other inputs
• Rise in production costs are passed on to consumers who have to pay higher prices for final goods and services

Costs of Inflation

Reduces Real Income (Purchasing Power)

• Buy less goods with same amount of money

Affects Interest Rates

• Real IR (nominal) must be positive for lenders to make profit and lend

International Competitiveness

• Country’s export at disadvantage when domestic inflation is greater than overseas
• Bad for Exports - Good for Imports

Currency Depreciation

• Less overseas demand for countries goods
• Good for Exports - Bad for Imports

Capital for Labour Substitution

• Due to wage inflation and structural change
• Substitute from labour to capital

Uncertainty for Decision Makers

• Investment decisions, reduce output and employment opportunities

Economic Efficiency

• People move away from productive to speculative activities (assets and investment): negative impact on economic output
• Productive activities increase GDP, speculative doesn’t

Hyperinflation

• Diversion of effort towards hoarding or non-productive activities

Increase in Income Inequality

• Bracket Creeps: As income rises with inflation, higher margin of tax leading to fewer tax brackets

Benefits of Low, Stable Inflation

Helps to maintain Low Real Interest Rates

• Supports economic confidence
• Encourage higher levels of consumption and investment

Creates Confidence about Growth of Economy

• Assets like houses will increase in value over time
• Changes in prices are predictable, allowing consumers/producers to comfortably = make long term decisions