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# Lecture 2

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
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
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

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

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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## What About Asset Price Inflation?

Source: www.rateinflation.com

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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
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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## Saving & Wealth

Saving a flow
Wealth a stock
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
Governments (budget surpluses).

## Discount for depreciation

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

## 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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Real
Interest
Rate

r*

I
I*=S*

S, I
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Real
Interest
Rate

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

S, I
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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?