Inflation

Stage 1 Economics, Slideshow 16

The concept of inflation
Inflation is an ongoing increase in the general price level
● People are talking about inflation if they say “prices keep going up”
or “the currency (or money) is losing its value”
● Ongoing means that the process keeps on happening; it is not a single
price increase
Inflation doesn’t mean that all prices have to go up, just most of them
● Different prices go up by different amounts at different times
● Some prices may even go down, especially high tech prices
(smartphones, USBs)
The Consumer Price Index (CPI)
Think of a bundle of everything you buy in a year - 20 kgs of rice,
180 litres of petrol, 12 shirts, a smartphone, 15 haircuts, and so on
● The CPI sort of represents the cost of buying one unit of that(?)
● Not everything we buy is included in the CPI - just the most
common things
The CPI is a weighted average of prices
● The weight of each item depends on how much of it we buy
● So rice would have a bigger weighting than potatoes
The Consumer Price Index (CPI)
It’s an index, which means the number itself doesn’t mean
anything (it has no units)
● But, by comparing the CPI from one year to another, you can
work out the percentage change in prices
● As with real GDP, there is a base year. The CPI in the base
year is set to 100
The measurement of inflation
Inflation is calculated as the % change in the CPI
So if the CPI in Year 1 is 173 and the CPI in Year 2 is 178…
...the inflation rate is (178-173)/173 = 2.9%
● As with economic growth, one decimal place is enough
The measurement of inflation
Look at the table and answer
the questions: Year CPI
1. Which year is the base
year? 1 90
2. Was inflation the same in
years 2 and 3? 2 100
3. If not, what was inflation in
year 2 and year 3 (to 1 dp)? 3 110
4. Why did I not ask you to
find inflation in Year 1?
Causes of Inflation
The main cause of inflation is governments printing too much
money
● “Printing” oversimplifies it - a better word would be “creating”
too much money
But how does this cause prices to go up?
The answer is a process called demand pull inflation
Demand Pull Inflation
In the circular flow model, more spending (demand) causes firms
to produce more, causing income to rise, and so on
But firms need more resources to produce more - what do they do
if there aren’t enough unemployed resources to use?
● They get resources from other firms by paying more for them
○ for example, by offering workers a higher salary, or
paying more to get an office
Demand Pull Inflation
Paying more to get resources increases the cost of production
● This increases the selling price of products, which means
inflation
● So the extra demand leads to higher prices
Note: the firms that get the extra resources produce more, but the
firms they get those resources from produce less
● Overall, production doesn’t go up, only prices go up
Demand Pull Inflation
So when there’s more money in the economy (ie created by the
government), this often leads to more spending (AE goes up)
● When the economy is at or near full employment (all the resources
are being used), more production by one firm means less production
by another firm
● The extra spending (ie extra demand) leads to higher prices
● Overall, production doesn’t go up, only prices go up. This is demand
pull inflation
Cost Push Inflation
When the cost of production rises, the prices of products rise
● Sometimes, the cause of the cost rises is NOT due to demand pull
inflation
● In these cases we call it cost push inflation
Examples of cost push inflation include:
● Oil prices going up (oil is a cost of many products, due to transport)
● Import prices rising due to the exchange rate falling
● Supply shocks across one or more industries, eg the covid pandemic
● Governments increasing prices, directly or indirectly (eg by
increasing taxes)
Demand Pull and Cost Push Inflation
Cost push inflation is more likely to have a one off effect, rather
than an ongoing effect
Demand pull inflation is the main “process” of inflation
● If governments continue to create more money, this process
will continue
● This process of inflation is what underlying inflation tries to
measure
Costs of Inflation - Output Effects
The effects of inflation are NOT this:
“People can’t buy as much as before due to the higher prices.”
This is wrong because incomes rise at the same time
● The extra money spent on higher prices goes to people as
higher income, that’s the circular flow
The actual effects of inflation are not so obvious
Costs of Inflation - Output Effects
The problem of inflation is that people have to react to it - if they
don't, the purchasing power of their money falls
Reacting to it costs people and businesses time and money
Not only that, but inflation makes it harder to make economic
decisions
● Especially firms deciding whether to do investment projects
In short, high inflation reduces a country's current and future
standard of living
Costs of Inflation - Distributional Effects
Another effect of inflation is not to reduce economic activity, but to redistribute
people's real income (or purchasing power)
Prices going up does not automatically make people worse off because, on average,
nominal income rises by the same amount that prices do
● But some people’s nominal income rises by more than prices, and others will
rise by less
● If your nominal income rises by more than the prices of things you buy, you
win from inflation (your real income goes up)
○ But if your nominal income rises by less than the prices of things
you buy, you lose from inflation (your real income goes down)
Costs of Inflation - Distributional Effects
The effects of inflation on different groups aren't definite...it depends on
what actually happens to many individual prices and incomes
● For example, it depends on which products you buy, as some prices
rise by less than others (or even go down)
But in general, (some) rich people tend to do better than poor people
● Partly because they can afford to take the steps that best respond to
inflation
○ Such as investing in real estate, which typically rises in line with
inflation
Contemporary Inflation in Australia
Demand pull and cost push factors both contributed to this increase
Demand factors
● a fast return to pre-pandemic production
● high government spending during the pandemic
● lots of extra money by the RBA (low interest rates)

Cost factors
● World supply chain disruptions - Ever Given, China
● War in Ukraine - grain and oil
● Domestic - electricity, rent
Contemporary Inflation in Australia
Inflation is coming down
because of action by the RBA
● Interest rates have been
increased, slowing down
economic activity
The details of this policy will
be covered in Stage 2 next
year, under the topic of
monetary policy