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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 general 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. Using the RBA’s inflation calculator, $312.80 in 1982 would purchase the equivalent of $898.96 in 2009. By August 2009, the average weekly earnings for all employees had increased to $934.70. This means that whilst money incomes appear to have increased considerably, the real increase in average weekly earnings was only $35.74.

You can try the RBA’s calculator by going to the RBA website: click on ‘Inflation rate’ in Key Information section, then click on ‘Inflation Calculator’. (See the link under the heading ‘More’.)

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%, close to the top of the target rate, 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 reached 4.4% in Debember 2008.

The weakening world economy and global recession caused inflation to fall in Australia, reaching 1.6% in December 2009, only to rise again as economic recovery got underway: In January 2010 inflation was 2.1%.

Content

1. Measuring inflation

   The inflation rate is measured by changes in the 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 equation.
   

   We can 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 aggregate demand are then the potential sources of demand inflation. For example, Government investment in infrastructure in 2009 as well as the upturn in housing construction meant that aggregate demand increased and inflationary pressures emerged in 2009/10. 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.

   • 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, large oil prices rises in 2001 had a significant impact on inflation, being a major cost of production and transport, whilst in January 2009 falling petrol prices resulted in the biggest quarterly CPI fall since 1997.

   • Imported inflation

     An increase in the price of imports will lead to an increase in inflation. Rising petrol prices were a major inflationary pressure in 2001, and global energy and food prices will continue to be a significant influence on inflation in Australia.
     
     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.
     
     Between 2005 and 2007 world oil prices rose dramatically with oil breaking through the $US100 a barrel mark in November 2007.
     
     The import price index fell by 3% in the September quarter of 2009. Falling commodity prices at the end of 2008 as well as appreciation of the Australian dollar helped to reduce inflation in 2009.

   • Inflationary expectations

     In an economy that is experiencing inflationary pressures, there are expectations by individuals and businesses that inflation will rise in the future, and this leads to actions that can of themselves create inflation. For example, workers will be concerned that the purchasing power of wages has fallen  and will reduce their standard of living. So, employees and unions build this into their wage claims. Businesses, in paying higher wages will find their costs of production have increased and will pass all or part of this on to consumers in the form of higher prices, thus resulting in cost inflation. Further, if consumers believe that prices will be higher in the future due to inflation, they may well decide to make purchases now when items are cheaper. This behaviour then actually feeds into demand inflation.

     Consumer expectations of 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. The Melbourne Institute survey of consumer inflationary expectations showed that expectations were quite low in May 2009 at 2.4%, but started to rise from June. By September inflationary expectations had increased to 3.5% and remained fairly constant for the remainder of the year and early 2010. (www.melbourneinstitute.com .)

3. Recent trends in inflation

   Historically 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, was attributed mainly to the one-off introduction the Goods and Services Tax (GST).

   During 2007and 2008 the Reserve Bank was worried about inflationary pressures building in the economy, as the economy was close to capacity with low unemployment 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.
   
   Inflationary pressures in 2009 were quite moderate. This was due to the domestic economic slowdown, subdued upstream price pressures (ie costs of production), a slowing in wages growth, appreciation of the currency and moderate inflationary expectations.
   
   In the second half of 2009, the largest contributors to inflation were rising prices of major household purchases (eg. Washing machines), automotive fuel and deposit and loan facilities. The downside pressures were falling prices of pharmaceuticals, fruit and vegetables and other financial services.
   
   In late 2009/early 2010 the Reserve Bank was concerned that a resources boom and associated housing and skilled labour shortages could fuel inflation, leading to three cash rate rises occuring in the second half of 2009. The RBA left interest rates on hold in February 2010 in order to assess the impacts of the previous tightening.
   
   

4. Effects of inflation on the economy

   Inflation is a very important economic aggregate for economists to watch. A small amount of inflation is desirable in any economy as this indicates to producers that there is rising demand and so stimulates increased production and hence economic growth. This is why the RBA’s inflation figure is between 2-3% rather than zero.
   
   Rapid or high inflation, however, is of concern. High inflation erodes real incomes, meaning that the purchasing power of consumers is decreasing. 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. This can set off a ‘wages price spiral’ where workers push for higher wages, paid for by businesses through increasing prices, leading to a further push for higher wages and so a cycle of ever rising wages and prices can result.

   When the cost of resources is increasing, in order to maintain profits 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 (such as pensioners) to shareholders, who receive profit and dividend income – these types of incomes typically increase during inflationary periods. Asset price inflation means that individuals who own assets such as property and shares find their assets are worth more. Rapid inflation therefore tends to increase income inequality.

   When the inflation rate in Australia is greater than our overseas trading partners, our international competitiveness is reduced. Increasing costs force up export prices, and 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, decreasing 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

Exercise 3

Read the following extract from the Reserve Bank’s website education section on Monetary policy and inflation, to answer the questions that follow.

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.