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Multiple Choice 1. C 2. B 3. B 4. C 5. A 6. B 7. A 8. A /C 9. A 10. C 11. B 12. A 13. B 14. B 15. A 16. D 17. C 18. B 19. A 20. C Question One a) Define the term inflation (1 mark) Inflation refers to a sustained increase in the general level of prices in an economy. The best known as most widely used measure of inflation in Australia is the percentage change in CPI. b) Calculate the inflation rate in year 2 (1 mark) 10% c) Outline ONE possible reason for the increase in inflation in year 3 (2 marks) Inflation may have increased in year 3 due to a depreciation of the Australian dollar which increased the domestic price of imports and leads to a rise in inflation. d) Explain the impacts of rising international prices on inflation in Australia (2 marks) Rising international prices would essentially cause an increase in the price of inflation in Australia. Rising Due to increased prices of imported goods, Australia is exposed to imported inflation where the price of its g/s too increase. e) Explain the relationship between inflation and economic growth (4 marks) Higher inflation distorts economic decision making since the producers and consumers change their spending and investment decisions in order to minimise the effect of inflation on them, such as through buying assets rather than investing in income-producing activities. Sustained low inflation is likely to encourage consumers to save a higher proportion of their disposable income. Just as high inflation erodes the value of savings lower inflation levels should reduce distortions to saving patterns. Question Two a) Outline TWO recent trends in Australia’s inflation rate (2 marks) One of the most significant macroeconomic achievements of the 1990s was that Australia achieved a sustained reduction in inflation rates after relatively high inflation since the 1970s. In 1992 the RBA began to target inflation are a rate averaging 2-3% in the wake of the Goods and Services Tax where inflation peaked at approximately 6% in June 2001. Conversely, the Global Financial Crisis of 2007-8 caused inflation to plummet at approximately 1.5% in June 2009. b) Discuss the impact of globalisation on Australia’s inflation rate (4 marks) Globalisation has generally caused Australia’s inflation rate to fluctuate. Australia is highly dependent upon its import trading partners to continually supply their goods and services, therefore the emergence of trade agreements especially with China has resulted in Australia’s inflation rate to increase. Floating the Australian exchange rate has significantly increased inflation volatility as changes of the $A will automatically impact the level of inflation. Analyse the impact of low inflation on Australia’s economic performance (4 marks) Lower rates of inflation within the Australian economy can lead to various outcomes on Australia’s economic performance. Sustained low inflation rate allows moderate economic growth to be maintained without it becoming necessary to curtail growth through higher interest rates. Sustained low inflation since the early 1990s allowed for a long period of relatively high economic growth. Low inflation can also have a beneficial effect on the level of economic growth because it impacts on investment and savings. Low inflation has a very positive impact on business investment, restoring the incentive to invest in long term productive assets rather than just short term speculative investments, which a higher inflation environment encourages. As a result, lower inflation is likely to encourage consumers to save a higher proportion of their disposable income. Low inflation should improve Australia’s international competitiveness, making it more attractive for other countries to purchase Australian goods and services, as well as making local goods more competitive with imports. This may lead to an expansion of exports and the replacement of imports by domestic substitutes, thus improving the CAD. Thus low inflation often leads to increased capital inflow and higher demand for the $A. Question Three a) Outline the relationship between inflation and unemployment (2 marks) The levels of unemployment and inflation share an extremely close relationship in the short term. Generally, high levels of unemployment often also have low rates of inflation and vice versa. This inverse relationship is derived from the level of economic growth. Increasing economic growth leads to declining cyclical unemployment as aggregate demand increases. In order to accommodate the increasing demand of consumers, firms increase their demand for labour as an input of production, placing upward pressure on the demand pull inflation as aggregate demand exceeds aggregate supply. b) Explain the relationship between productivity and inflation (3 marks) The link between productivity and inflation is well associated with wage levels. High productivity enables greater dynamic efficiency and hence reduces the effects of demand-pull inflation. Productivity specifically has the impact ensuring greater production of goods and therefore minimises inflation volatility as the cost of living and hence consequent nominal wage demands are stabilised. c) Discuss the policies available to the government to reduce the level of inflation in the Australian economy (5 marks) There are a number of macroeconomic and microeconomic policies available to the government to help combat inflation. However, the main tool used by the government is monetary policy, as it is able to be implemented immediately, and is most effective in containing inflation. Actions by the RBA address inflation by selling government securities to increase the cash rate. This results in a rise in the overnight interest rate where investment spending and consumer spending declines, encouraging consumers to borrow. Higher interest rates also trigger capital inflow which causes the $A to appreciate leading to a decline in the demand for exports and consequently a fall in aggregate demand from the export sector. Simultaneously, imports will also experience a decline in domestic demand as the price of imports will relatively be cheaper. As a result, demand-pull inflation and imported inflation both decrease whilst the private sector becomes more alert of the RBA’s actions in increasing the interest rate, causing a decline in inflation and a reduction in inflationary expectations. Macroeconomic policies also cater for inflation in the long term by minimising costpush inflation. Such policies can be in the form of tariff reform, labour market policies and the deregulation of financial markets. Labour market reforms include the introduction of enterprise bargaining and workplace agreements. This means that wage rises are increasingly linked to productivity and minimises excessive wage growth that is not linked to productivity increases, resulting in lower cost-push inflation.