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Outcomes
Overview
Content
Review exercises
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Outcomes

HSC Topic Three - Economic Issues is described in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 37 - 39. The specific outcomes from the syllabus for this tutorial are listed below. A student:

H1	demonstrates understanding of economic terms, concepts and relationships
H2	analyses the economic role of individuals, firms, institutions and governments
H4	analyses the impact of global markets on the Australian and global economies
H7	evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments
H11	applies mathematical concepts in economic contexts.

From Economics Stage 6 Syllabus © Board of Studies NSW 1999.

Being up to date and aware of contemporary issues

Economics students need to be aware of what is happening in the Australian Economy today and should, for instance, know what recent decisions have been made by the Reserve Bank of Australia - and why.

Students are advised to reflect on the information here and consider it in light of what they know is happening currently. Up to date statistics may be found by visiting relevant websites such as that of the Australian Bureau of Statistics. Three excellent websites for sourcing updated statistics can be accessed by scrolling down to the MORE section at the bottom of this page.

Overview

Inflation occurs when there is an increase in the level of prices that effectively reduces the purchasing power of income. For example, in March 1982, the average weekly earnings for all employees was $312.80. By March 2002, the average weekly earnings for all employees had increased to $839.00. This means that to buy the same amount of goods and services in 2002 and maintain the relative purchasing power of 1982 required an increase in money income of $526.20.

Inflation, like unemployment, is a major economic problem and is linked to changes in the level of economic activity. It is for this reason that the Reserve Bank of Australia (RBA) attempts to keep the inflation rate in the targeted range of between 2% and 3%.

The following graph from Australia's Reserve Bank shows inflation in Australia in the last 40 years.

The inflation rate in Australia from June 2001 to June 2002 averaged 2.8%, prompting concerns about inflationary pressures in the economy. In the face of such concerns the RBA increased interest rates in May and June 2002. Inflation fell as a result and remained at around 3% between 2002 and 2007. In 2007 and 2008 inflation started to rise as the economy was fully employed and economic growth was high. It was believed that Australia was at its production possibility maximum and was using all factors of production.

Inflation increased until 2008, however the weakening world economy and great recession was expected to cause inflation to fall in Australia.

Content

1. Measuring inflation

   The inflation rate is measured by changes in Consumer Price Index (CPI).

   The CPI is an index that measures the quarterly changes in the prices of a selected weighted “basket” of consumer goods and services.

   The basket includes a wide range of goods and services purchased by metropolitan households, such as food, alcohol and tobacco, clothing and footwear, housing, health, transport, communication, recreation and education. This method of measuring inflation is the one that most people and businesses would be familiar with, it is known as the headline inflation rate.

   Since 1998, the RBA has used the headline rate of inflation to assess monetary policy changes and keep inflation within the targeted range.

   The headline inflation rate can be calculated using the following relationships.
   

   Use the following information to calculate the inflation rate for Year 3.

    

   	Year 1 (base year)	Year 2	Year 3
   Consumer Price Index	100	105	110

   

   Another measure of the inflation rate is the underlying rate of inflation. The underlying rate of inflation is calculated by removing one-off economic impacts. For example, seasonal effects such as higher food prices that are caused by drought or when the RBA tightens its monetary policy by increases in interest rates. The treasury uses this method of measuring inflation for the purpose of economic forecasting.

2. Causes of inflation

   There is generally, no single factor that contributes to the inflation rate. Typically, at any single time there are several factors working together to fuel inflationary pressures in the Australian economy. Some of these factors are outlined following.

   • Demand inflation or demand-pull inflation

     This type of inflation occurs when the level of aggregate demand in the economy is greater than aggregate supply. Remember:

     
     
     
     
     

     C = consumption expenditure

     I = investment expenditure

     G = Government expenditure

     X = exports

     M = imports

     The main components of aggregated demand are then the potential sources of demand inflation. For example, between June 2001 and June 2002 lower interest rates and higher consumer and business confidence saw household consumption increase by 4.5% with business investment rising by 15.8%. Imports also increased by 11.9% during this period.

     The RBA, concerned about strong domestic demand in these areas, increased interests rates in May and June 2002 to reduce inflationary pressures.

     In recent years, growth in the export sector has generated inflationary pressures as income, consumer spending and investment increased. However, the global downturn and the events of 11 September 2001 have seen export growth decreased by 1.5% from June 2001 to June 2002.

     An increase in government expenditure (G) on goods and services or tax cuts can increase demand and the rate of inflation. Also, when the Government borrows money from the domestic financial market to finance a deficit budget, higher interest rates may result, increasing the cost of borrowing to business.
     
     During 2007and 2008 the Reserve Banks was worried about inflationary pressures building in the economy, as the economy was fully employed and economic growth was high. As a result the Reserve Bank increased interest rates to moderate economic growth and keep inflation under control. It increased interest rates 6 times to meet these economic policy objectives. Once the recession started to increase unemployment and economic growth fell, the Reserve Bank reduced interest rates over a significant period to increase economic activity.

   • Cost-push inflation

     Cost-push inflation results from increases in costs of production. These increases in costs may be caused by wage increases that are not linked to productivity, or by a rise in the cost of raw materials used in the production process.

     For example, the rise in interest rates during 2002 reduced the cash flows of many businesses. These cost increases will eventually be passed onto consumers as higher prices.

   • Imported inflation

     A depreciation in the value of the Australian dollar increases the price of imported goods and services to domestic consumers and producers. Such an effect occurred in 1999 when the dollar depreciated 15.0% against most world currencies.

     Inflation rates can also be affected when the price of imported goods from other countries increases. For example, in 2001 world oil prices increased dramatically as international suppliers reduced production resulting in increased petrol prices and transport costs.
     
     Between 2005 and 2007 world oil prices rose dramatically with oil breaking through the $US100 a barrel mark in November 2007.

   • Inflationary expectations

     In an economy that is experiencing inflationary pressures, there are expectations by workers that the purchasing power of wages and therefore the standard of living will decline. For example, consumer expectations of higher inflation were at a high of 7.5% in May 2000 before the introduction of the GST. Expectations fell to 4.5% in August 2001 and 3.5% in June 2002.

     In such an economic climate, trade unions would build into wage increases an amount for anticipated inflation rates rather than use current levels as a guide. Businesses are aware of such actions, and generally increase prices, consequently adding to cost - push inflation in the economy.

3. Recent trends in inflation

   Traditionally Australia has had an inflation rate that has been relatively higher than our major trading partners. During the 1970s and 1980s inflation averaged between 6.0% and 10.0%. However, from 1992 to 2001 the average level had declined to just over 2.0%.

   During 2000/01 the inflation rate averaged 6.0% overall. This rate, which was well above the RBA target, attributed mainly to the introduction the Goods and Services Tax (GST).

   Year and Quarter	Inflation Rate	Consumer Price Index
   2005/06
   Sep	2.0
   Dec	2.8
   Mar	3.0
   June	4.0
   2006/07
   Sep	3.9
   DEC	3.3
   Mar	2.4
   Jun	2.1
   2007/08
   Sep	1.9
   Dec	3.0
   Mar	4.2
   Jun	4.5
   2008/09
   Sep	5.0
   Dec	3.7
   Mar	2.5

   MARCH KEY FIGURES

   	Dec Qtr 2008 to Mar Qtr 2008	Mar Qtr 2008 to Mar Qtr 2009
   Weighted average of eight capital cities	% change	% change
   Food	2.2	5.7
   Alcohol and tobacco	1.0	5.7
   Clothing and footwear	-0.5	2.1
   Housing	0.9	5.5
   Household contents and services	0.8	1.9
   Health	4.4	5.3
   Transportation	-1.5	-4.6
   Communication	0.4	1.0
   Recreation	-1.1	0.5
   Education	5.4	5.0
   Financial and insurance services	-6.3	-1.4
   All groups	0.1	2.5
   All groups excluding Housing and Financial and insurance services	0.8	2.1

   
   

   All groups, Quarterly changeContribution ot quarterly change, March quarter 2009

   

   MARCH KEY POINTS
   
   THE ALL GROUPS CPI

   • rose 0.1% in the March quarter 2009, compared with a fall of 0.3% in the December quarter 2008.
   • rose 2.5% through the year to March quarter 2009, compared to an annual rise of 3.7% to December quarter 2008.
   
   OVERVIEW OF CPI MOVEMENTS
   • The most significant price increases were pharmaceuticals (+13.0%), rents (+1.7%), secondary education fees (+7.6%), vegetables (+6.0%), and electricity (+3.6%).
   • The most significant offsetting price falls this quarter were for deposit and loan facilities (-14.1%), automotive fuel (-8.1%), domestic holiday travel and accommodation (-5.1%) and overseas holiday travel and accommodation (-4.0%).

   Source ABS Consumer Price Index

4. Effects of inflation on the economy

   As prices increase in the economy there typically will be pressure by trade unions to increase wages to match the reduction in real incomes. If wage increases do not match the price increases, living standards will decline.

   When the cost of resources is increasing, producers have to raise prices, or in an attempt to remain competitive, reduce their labour force, which adds to unemployment levels.

   As inflation reduces real income, a redistribution effect occurs, away from wage earners and fixed income earners to shareholders, who receive profit and dividend income.

   When the inflation rate in Australia is greater than our overseas trading partners, our international competitiveness is reduced as increasing costs force up export prices. Imports become cheaper relative to domestically produced goods, resulting in Current Account Deficit (CAD) problems.

   As the inflation rate increases the level of real savings is reduced. There is pressure on interest rates to rise, fueling cost inflation, the profitability of businesses and the purchasing power of consumers.

   The level and types of investment and the allocation of resources in the economy are also affected. As the costs of borrowing (interest rates) rise, investors look to more profitable speculative investments, such as real estate, shares and bonds. This can have an adverse effect on economic growth as investment in the productive capacity of the economy reduces.

   The government budget outcomes are also affected by inflation. For example, the budget surplus is reduced or the deficit increased as the cost of providing goods and services increases. However, government income tax revenue increases as wage earners receive pay rises and move into higher tax brackets. This is referred to as bracket creep.

Review exercises

Exercise 1

Using the following information calculate the inflation rate in the March quarter 2002.

Answer

	December quarter 2001	March quarter 2002
CPI	135.4	136.6

 

Exercise 2

Read the extract RBA is pulling the right levers and outline two impacts that high levels of inflation can have on the Australian economy.

Answer

Monetary policy and inflation
So far the discussion has mainly focussed on the effects of monetary policy on aggregate demand. To complete the picture, we need to consider how monetary policy affects inflation. Leaving aside the direct effect operating through the exchange rate on import prices, monetary policy can be thought of as affecting inflation through two main channels.

First, monetary policy affects inflation indirectly, via its effect on aggregate demand and economic activity. When demand runs ahead of the economy's productive capacity, it tends to put upward pressure on inflation – for example, buoyant demand enables producers to widen their margins, while strong demand for labour tends to strengthen the ability of employees to bargain for higher wages. These effects on wages and prices are interdependent. Price increases encourage demands for higher wages, while wage increases add to costs which in turn are often passed on in higher prices. This interdependency gives considerable inertia to the inflation process. Once wages and prices start to accelerate they are hard to slow down, underlining the need for early policy action when inflationary pressures start to develop.

None of these effects operate instantaneously. When a situation of general excess demand starts to develop, it may take some time before this becomes evident in higher prices and wages. It also takes some time for the effects of monetary policy to work through the economy. So in seeking to control inflation, monetary policy has to be anticipatory. This means that policy decisions need to be based on forward-looking assessments of inflation trends and prospects, based on the best currently-available information.

Some of these points are illustrated in Graph 9, which summarises aspects of the policy experience in the past few years. Of particular interest is the episode in the mid-1990s when inflation briefly rose above the 2-3 per cent range, before falling back to a rate of around 2 per cent. Inflationary pressures were generated by a surge in growth as the pace of recovery from recession picked up in 1993 and 1994, but inflation itself did not increase until a year or two later. The important point here is that policy was conducted in a forward-looking fashion. Interest rates were raised early in this episode to forestall the inflationary pressures and, likewise, they were lowered in 1996 and 1997 as the inflationary pressures eased.

Secondly, monetary policy can affect the inflation process more directly by influencing expectations. Cyclical demand pressures can be thought of as moving the inflation rate relative to where it is currently expected to be. But those expectations in turn depend on the overall policy climate and the historical inflation experience. Part of the role of policy is to set a climate that is conducive to maintaining expectations of low inflation. To the extent that policy is successful in achieving this, it will make it easier to keep inflation low, and will help reduce the cost of bringing inflation down when necessary to do so.

In recent years, policy-makers and economists around the world have focused intensely on the question of how this kind of favourable influence on expectations can be achieved. Part of the answer that is usually given relates to the design of the policy system. A system that clearly states the inflation objective, and contains a clear commitment to achieving it, can help to focus the public's inflation expectations. This is an important part of the thinking behind the move to inflation targets in many countries. But equally important is that these commitments have to be demonstrated in the actual conduct of policy. While public commitments can help to shape expectations, in the end they will only be believed if policy is conducted in a way that is consistent with them.

Source Reserve Bank (http://www.rba.gov.au/Education/monetary_policy.html )

Exercise 3

1. What are the major causes of inflation in the Australian economy?

   Answer

2. Outline two factors that contributed to the reduction in the inflation rate in the Australian economy during the 1990s.

   Answer

3. Why is the underlying rate of inflation seen by economists as a better measure of inflation than the headline inflation rate?

   Answer

4. Describe two economic factors that could determine the future level of inflation in the economy.

   Answer

Exercise 4

Questions	Answers
a. Cost-push inflation is characterised by rising production costs.	True	False
b. An increase in the level of domestic savings is likely to reduce Australia’s inflation rate.	True	False
c. Expectations of rising inflation rates do not add to inflationary pressures in the economy.	True	False
d. High levels of domestic inflation will reallocate resources to speculative areas of the economy, for example real estate.	True	False
e. A large increase in the price paid for imports by domestic producers has little or no impact on the level of inflation.	True	False
f. Demand inflation occurs when the total supply of goods and services is insufficient to meet aggregate demand in the economy.	True	False
g. A deficit budget can generate inflationary pressures in the economy.	True	False
h. Bracket creep occurs when wage earners move into lower tax brackets.	True	False
i. Inflation reduces the real purchasing power of money.	True	False
j. High levels of inflation can reduce Australia’s international competitiveness.	True	False

Answers

More

The Australian Bureau Statistics has a number of catalogues and media releases that can be used to update statistics in this tutorial.

If you need to conduct some research on monetary policy and inflation the Reserve Bank of Australia has a media file that can be accessed for current press releases and statistics.

If you are looking for some statistics on Australia’s inflation rate compared to other countries or any other material on international economic issues then the World Bank , the Institute for International Economics and the International Monetary Fund are good sources of information.