Inflation revision questions

How would you define inflation?

A persistent increase in the average price level in the economy.

Inflation is measured using the CPI or RPI. What do these two stand for?

Consumer Price Index and Retail Price Index. There are a number of different measures of inflation in use. The most frequently quoted and most significant ones are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).

One of the costs of inflation is a loss of purchasing power. What does this mean?

If there is inflation then your money is worth less year on year. For example, $100 this year would not buy you $100 worth of good or services next year if inflation had been 10% over that period. This can be particularly problematic if your wages don't rise with inflation?

Another cost of inflation is the effect it can have on your savings. What does this mean?

If inflation is higher than the interest rate that banks are giving then you would find that you are actually losing money by putting it in the bank. For example, if inflation is 8% but interest rates are only 6% then real rate of interest would be negative.

What impact would you expect high levels of inflation to have on international competitiveness?

If a country has a higher rate of inflation than that of its trading partners, then this will make its exports less competitive, and will make imports from lower-inflation trading partners more attractive. This may lead to fewer export revenues and greater expenditure on imports, thus worsening the trade balance. It might lead to unemployment in export industries and in industries that compete with imports.

Why might inflation lead to labour unrest?

If workers believe their wages are not keeping up with inflation they will be dissatisfied and this will lead to disputes between employers and unions.

What is a union?

This is the situation where a group of workers come together for collective bargaining etc. with employers. Grouping together in a union effectively gives them more power.

We are able to broadly divide the causes of inflation into to main types. What are these?

Demand pull and cost push inflation.

What is demand pull inflation?

This is as a result of increasing demand in an economy. This would happen when the economy is either approaching or already at the full employment level.

Can you show demand pull inflation on a Keynesian LRAS curve?

...

True or false, demand pull inflation could be caused by increasing demand for exports?

This is true. This could be due to increasing incomes in the economies of a country's trading partners.

A change in any of the components of demand can result in demand pull inflation. What are these components?

C+I+G+(X-M)

True or false, demand pull inflation could be caused by a decrease in trade union power?

False. This is more to do with cost push inflation where an INCREASE in trade union power can push up costs of production and therefore prices.

What is cost push inflation?

A rise in the general price level resulting from an increase in the cost of production.

Can you show cost push inflation diagrammatically?

Broadly, what causes cost push inflation?

A increase in any of the costs of production, such as increases in labour cost due to trade unions demanding higher wages.

Is it possible to have both demand pull and cost push inflation at the same time?

Yes it is. Demand pull inflation would result in higher prices which would likely result in workers demanding higher wages to counteract the higher prices. This then puts pressure on costs of production leading to cost push inflation.

What might be an appropriate policy to reduce demand pull inflation (broadly)?

Demand management policies aimed at reducing AD.

What are the two broad demand management policies available to governments?

Deflationary fiscal policy and/or deflationary monetary policy.

What does deflationary fiscal policy include?

Increasing taxation and reducing government spending.

What does deflationary monetary policy include?

Increasing interest rates and reducing the money supply.

Who actually implement monetary policy in most western economies today?

Central banks.

Which is the most effective policy to deal with increasing AD that leads to pressures on inflation?

Monetary policy is more effective as it is 'faster' to put in place and less harmful to governments (fiscal can make governments very unpopular).

If the reason for inflation in an economy is due to cost push factors, what set of broad policies should a government adopt?

Supply side policies.

If the CPI is 3% what does this actually mean?

The inflation rates are expressed as percentages. If CPI is 3%, this means that on average, the price of products and services we buy is 3% higher than a year earlier.

Or, in other words, we would need to spend 3% more to buy the same things we bought 12 months ago.

What might be a typical target level for inflation for Australia?

2 - 3%

What is hyperinflation?

When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as a store of value and also as a medium of exchange.

Why might a depreciation of the exchange rate lead to inflation?

It would increase the price of imports and reduce the foreign price of Australian exports. If consumers buy fewer imports, while exports grow, AD in will rise.

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