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Lecture 2

Measuring Macro Performance:


The Price Level
Savings & Wealth

Consumer Price Index (CPI)


Define a base year.
Determine basket of goods and services
consumed.
Cost of base year basket in current year
CPI
Cost of base year basket in base year

CPI=1.25 prices 25% higher in current


year compared to base year.
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Cost of Living Indices I


Ideal cost of living index:
A: Determine the cost of the utility-maximising
consumption basket in the base year (say year
2000).
B: Determine the minimum cost of the current
year (i.e. 2011) consumption basket required to
yield base year utility at current year prices.
Index value = B/A

Calculated based on prefs, not purchases


This is how the CPI should be calculated!
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Cost of Living Indices II


Laspeyres Index:
A: Determine the cost of the (utility-max.)
consumption basket in the base year.
B: Determine the cost of purchasing the same
consumption basket in the current year.
Index value = B/A

Does not account for changes in demand


due to price changes.
Laspeyres Index > Ideal index (if p )
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Cost of Living Indices III


Paasche Index:
A: Determine the cost of the current year
consumption basket.
B: Determine the cost of purchasing the same
consumption basket in the base year
Index value = A/B

Does not account for changes in demand


due to price changes.
Paasche < Ideal < Laspeyres (if p )
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Cost of Living Indices IV


In fact, a chain-weighting process is used
to measure the CPI.
Weights updated every 5 years using
consumption data from the Household
Expenditure Survey (HES).
New series formed and linked to earlier series

RBA measures:
Excluding volatile items
Trimmed mean (middle 70% of p changes)
Weighted median

Inflation
% change in the CPI over some period
From previous quarter
From corresponding quarter in previous year

An aggregate of price changes


Alternative measures of inflation:
Underlying inflation
The trimmed mean

Deflation
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Inflation is costly

Shoe-leather costs
Noise in the price system
Tax system distortions bracket creep
Unexpected redistribution of wealth
Distorts firm and household decisions
Menu costs
Reduces real value of debts
reboot the economy after a debt binge!
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But deflation is bad too


Real value of debts rises
Debt burden increases.

Consumers put off purchases


Firms profit margins decline
Bankruptcy & unemployment

Inflation like the oil that greases the


economic wheel.
Need some of it, but not too much!
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Source: www.rateinflation.com
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Australia CPI Contribution Weights


Expenditure Group 2010 Weight (%) 2011 Weight (%)
Food

15.44

16.84

Alcohol & Tobacco

6.79

7.06

Clothing & Footwear

3.91

3.98

Housing

19.53

22.30

House contents/serv.

9.61

9.10

Health

4.70

5.29

Transport

13.11

11.55

Communication

3.31

3.05

Recreation

11.55

12.56

Education

2.73

3.18

Finance/insurance

9.31

5.08

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Australias CPI: June 2012


Expenditure Group

6/10-6/11

6/11-6/12

Food

6.1

-3.2

Alcohol & Tobacco

5.6

3.8

Clothing & Footwear

1.1

0.6

Housing

4.6

3.4

House contents/serv.

0.1

0.7

Health

4.0

3.6

Transport

3.5

2.1

Communication

0.4

0.9

Recreation

-0.3

-1.6

Education

5.9

6.1

Finance/insurance

4.2

2.9

Total

3.6

1.9

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Australias CPI: June 2012


Biggest price rises this quarter:
hospital/medical services (+2.8%), rents
(+1.1%), vegetables (+5.2%), furniture (+4.5%).

Biggest price falls:


Domestic holiday travel & accomm. (-4.0%),
audio visual and computing equipment (-3.8%),
cakes and biscuits (-2.8%)
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58% CPI weight

42% CPI weight

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What About Asset Price Inflation?


Source: www.rateinflation.com

Source: Standard & Poors

Source: NYSE data

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Interest Rates and inflation


The real interest rate (r):

r i
Where,
i = the nominal interest rate
= the inflation rate

Currently in US: negative real interest rates!


What determines the real interest rate?
Fisher: determined by S and I
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1st Oil
Shock

2nd Oil
Shock

91
Rec.

9/11

GFC
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Does the CPI measure inflation


accurately?
Asset prices under/over-estimate
Quality adjustment bias overestimate
How account for new goods?
E.g. health care

Substitution bias overestimate


CPI basket is fixed, but consumers may
switch to cheaper goods.
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Savings & Wealth

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Saving & Wealth


Saving a flow
Wealth a stock
Saving involves a trade-off
Consume today or tomorrow
Opportunity cost of saving?

The pattern of savings matters


Who? How much?
Domestically, internationally.
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What are National Savings?


Gross savings consist of savings by
Households
Businesses (retained earnings)
Governments (budget surpluses).

Discount for depreciation


When Savings < Capital Investment
Current account deficit (capital account
surplus)
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Australias National Savings

Source: Allen Consulting Group 2007

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Some Definitions
Y=C+I+G
national income = total expenditure

S=Y-C-G
national saving

S=(Y-T-C)+(T-G)
T=taxes
National saving=private + public saving
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Who is saving in Australia?

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Source: Allen Consulting Group 2007

Do Australian Households Save


Enough? Maybe

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Source: Allen Consulting Group 2007

Maybe not

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Source: Allen Consulting Group 2007

Why do National Savings matter?


Saving finances future investment.
If domestic savings low, must borrow from
overseas risky? In the long run yes, in
the short run, it depends credit markets
can be fickle
Japan (Govt debt)
US (Govt & Household debt)
Ireland, Greece, Spain Euro crisis
Australia (Household debt)
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National Savings matter


National savings can provide a buffer
against financial crisis
Asian financial crisis, China currently

But excessive savings also problematic


Global imbalances & the GFC
Germany badly hit

And what about ageing population issue?


Intergenerational equity (future tax burden)
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Global Imbalances I

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Source: Prasad (2009) Finance and Development

Global Imbalances II
AFC

GFC

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Global Imbalances III


Where did the excess savings go?
To the USA, UK, Australia, Ireland, Spain etc.

Excess supply of money leads to


Lower interest rates

Complacent monetary policy


Interest rates kept too low for too long
Interest rates raised too slowly
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What determines national savings?

Life-cycle saving
Precautionary saving
Bequest saving
The real interest rate
Financial innovation
Financial deregulation
Asset price booms
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S, I and the Real Interest Rate


Real
Interest
Rate

r*

I
I*=S*

S, I
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Positive Technology Shock


Real
Interest
Rate

r*
r*
I
I
I*=S* I*=S*

S, I
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Govt Spending Crowds Out Private I


S
Real
Interest
Rate

r*
r*

I
I*=S*

I*=S*

S, I
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Firm Investment Decisions


Expected cost vs expected benefit
Should a firm purchase an asset? (E.g.)
Price of asset ($4000)
Cost of borrowing (6% p.a.)
Net revenue from asset ($6000)
Tax (20%)
Opportunity cost (best outside option: $4400)
Depreciation (0% here)

Yes
Benefit=6000-1200-4400=400 > Cost=240
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Conclusion
You should now be able to discuss:
What is inflation? How is it measured?
Inflations link to interest rates.
Australias savings performance
Why are national savings important?
The link between S, I and the real interest
rate.
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