(i) Explain the concept of the consumer price index (CPI) and explain how it is measured. What is the latest CPI figures in Australia (Sept 2012) and what were the main factors influencing the CPI movements in this quarter.
(ii) Is the CPI an accurate measure of inflation? Explain the importance of inflation when calculating the real interest rate.
(iii) What are the economic costs of inflation?
(iv) Is deflation a potentially more serious problem than inflation?
In writing your answer you should refer to Chapter 1 of the textbook and the article “Inflation, deflation and all that” available on the Macroeconomics 1 website in Week 1: Unit 1 readings. For the latest statistics refer the Australian Bureau of Statistic website: http://www.abs.gov.au
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Submission question 1
The CPI, which is the abbreviation of the consumer price index, is an important index of measuring the cost of living. According to Australian Bureau of Statistics (ABS), “In Australia, the CPI measures the changes in the price of a fixed basket of goods and services, acquired by household consumers who are resident in the eight State/Territory capital cities.”(Australian Bureau of Statistics, 2012). The calculation of CPI requires three steps and they are conducted by the ABS. The CPI for a specific period measures the cost of consumption of goods and services in that period which is related to that in the chosen base year. (Bernanke, Olekalns&Frank 2011)
According to ABS, The CPI figures in Australia in September 2012 is 182.9, it increaed1.4% in this quarter, compared with an increase of 0.5% in the previous quarter (June 2012). The ASB also states “The most significant price rises this quarter were for electricity (+15.3%), international holiday travel and accommodation (+6.6%) and medical and hospital services (+4.5%). The most significant price falls these quarters were for automotive fuel (-3.9%) and motor vehicles (-1.0%).”(ABS 2012)
One of the most important aims of CPI is to measure the change in the cost of living and the change in the value of currency. In order to measure these changes, the inflation rate is needed. It is calculated by using the CPI figures. The inflation rate refers to the percentage change of CPI during a specific time period.
The CPI can also be called the cost of living index. When calculating the amount of money that the households need to pay in order to achieve a certain living standard, CPI has two main limitations. The first one is that CPI cannot measure all the cost of living. Moreover, the factors that contribute to the cost of living sometimes cannot be measured accurately. Due to the two reasons, CPI is not a very accurate measure of inflation. (Bade&Parkin 2010)
“The real interest rate is the nominal interest rate adjusted to account for the currency’s loss of purchasing power.”(Steve Saville, 2008,p1) in order to achieve the figure of real interest rate, the inflation is deducted from the nominal interest rate. If the inflation goes below zero, the real interest rate will be affected and it need to match the decrease of inflation or the increase of deflation. It is due to the nominal interest rate should not be negative.
Inflation can decrease the potential GDP and slow down the growth of economy, in addition it can also consume people’s leisure time. All of these are due to the six main cost of inflation. They are the shoe-leather cost, which is caused by the increased currency circulation speed and the increasing visiting to the banks; ((Bade&Parkin 2010) The noise in the price system, which is caused by the transmission of information is obscured by inflation, and as a result, it decreases the market efficiency; the distortions of the tax system, which is caused by the non-indexed tax system; the unexpected redistribution of wealth, which is caused by non-indexed wages. In addition, the costs also include the interference with long run planning and the menu costs. (Bernanke,Olekalns &Frank 2011)
According to Mr. GR Stevens, “ deflation is a generalized and persistent decline in most, if not all, prices for goods and services. More likely than not this, if it occurred, would be accompanied by declines in prices for many real assets and pressure for, even if not the actuality of, declines in wage and salary incomes.” (Mr. GR Stevens 2002,p11) Deflation can be a problem when it relates to the real interest rate. The real interest rate can be calculated by deduct inflation rate from nominal interest rate. Economists states that the nominal interest should not fall below zero, in this circumstance, If the inflation falls become negative to deflation, then, the real interest rate figure should not smaller than the deflation figure, otherwise, the nominal interest rate will below zero. In this situation, the problem of deflation will occur when the nominal interest is under the zero limits. The real interest rate has to increase to match the increase of deflation. In addition, when the real interest rate increases, people tend to spend less in the economy, it may also cause problem for certain kind of government policy to implement. ((Bernanke, Olekalns &Frank 2011)
Bade&Parkin 2010 “ Foundations of Macroeconomics 4th ed.” pp144-145, p148, pp317-318 Pearson Education, Inc
Bernanke, Olekalns &Frank 2011 “ principles of Macro economics 3rd ed.” p25,pp26-28,pp31-33, Australia, McGraw-Hill Australia Pty Ltd Steve Saville 2008 “The real interest rate” http://news.goldseek.com/SpeculativeInvestor/1221571691.php
Mr. GR Stevens 2002 “inflation, Deflation and All That” Australian Business Economists 2002 Forecasting Conference Dinner, Sydney, p11
Australia bureau of statistics “6401.0 – Consumer Price Index, Australia,”2012 http://www.abs.gov.au/ausstats/abs@.nsf/mf/6401.0
Australia bureau of statistics “Australian Consumer Price Index (CPI)”2012 http://www.rateinflation.com/consumer-price-index/australia-cpi
Australia bureau of statistics “Consumer Price Index FAQs “What is a Consumer Price Index (CPI)?”2012 http://www.abs.gov.au/websitedbs/webfaq.nsf/home/consumer+price+index+faqs#Anchor1