Download INFLATION Inflation is defined as the steady and persistent rise in

INFLATION
Inflation is defined as the steady and persistent rise in the general level of
prices. The purchasing power of money is eroded.
During inflation, some prices might actually fall (for example, certain items
of technology). Inflation is NOT: some goods rising in price as a result of
increased supply or demand, the result of seasonal change (e.g.
drought), a sharp increase in prices, or a temporary change. When
inflation occurs, it is a macro economic event. It reduces the purchasing
power of money.
Inflation and Disinflation
DEFLATION is the opposite of inflation. It occurs when the average price
level is falling.
DISINFLATION is defined as a fall in the rate of increase in inflation. In other
words, it is inflation occurring at a slower rate.
Changes in the value of money
There are four main functions of money:
A medium of exchange
A measure of value
A means of deferred payment
A store of value
In times of inflation, money is still useful for immediate purposes – buying
things and deciding which of the alternatives offers the best value for
money. However when the time between an agreement and payment is
split, inflation distorts purchasing power. Inflation encourages people to
act now, without thinking about the future. It encourages a “now”
mentality.
MEASURING INFLATION
Price indexes
A price index helps us see changes in statistics. An index has a start time, a
base year, which all measurements are made from  A value is
calculated for this base year  In the next and subsequent years, the
same value is calculated.
STEP ONE – Choose a base year
STEP TWO – Choose what is to be included in your index
STEP THREE – Determine any weightings needed
The CPI
The Consumers Price Index (CPI) measures the change in the price of
goods and services purchased by private households in NZ over a period
of time. This change in prices is sometimes called inflation. Where possible,
prices are collected for exactly the same goods and services each time,
to ensure changes in the cost of goods and services are not due to
changes in quantity or quality. These changes are called “pure” price
changes.
Sometimes there is a change in the quantity and quality of the goods, but
the prices remain the same (e.g. the packaging of a particular brand of
biscuits changes, and the number of biscuits is reduced, but the price
remains the same). This is, in effect, a price increase and adjustments are
made to record a price increase in the CPI.
HOW IS THE CPI ORGANISED?
The goods and services covered by the CPI are classified into nine groups,
21 subgroups, and 73 sections. The nine groups are: food, housing,
household operation, apparel, transportation, tobacco and alcohol,
personal and health care, recreation and education, and credit services.
Over 700 items are price-surveyed for the CPI.
Prices are surveyed in 15 urban areas throughout New Zealand. Surveys of
prices are carried out by post, internet, telephone and email.
Prices are weighted according to their importance in the basket of goods
and services that is used for the Consumers Price Index (CPI). Population
weights are used to find regional average prices. This ensures that the
price movements in, for example, the Auckland urban area have a
greater effect on the CPI than those in Timaru, a much smaller area.
USES OF THE CPI
Used to adjust wages and salaries by employees negotiating with their
employers to make their employment agreements
Used to adjust welfare benefits, as the government will adjust these for
changes in the cost of living for beneficiaries so their purchasing power
remains the same
The Reserve Bank also uses CPI to manage monetary policy and assist
in determining where the Official Cash Rate should be to remove the
effect of interest rate changes, making it at the CPIX
LIMITATIONS OF THE CPI
The CPI measures a typical basket of goods that would be bought by
an average New Zealand family. “Typical” and “average family” are
abstracts that don’t exist, in the sense that the statistical average family
in New Zealand has 1.8 children and the index includes baby food and
shoes, petrol and alcohol.
The CPI is a weighted index – weighted to represent the buying
patterns of what type of family? Buying for a family with teenagers is
not the same as buying for a family with preschoolers. It is an average,
an approximation “across the board”.
Where does the “typical” New Zealand family live – town or country,
Wellington or Auckland, Gore or Timaru? The prices ruling in different
places vary considerably. The CPI can only make an estimate of the
average price in New Zealand, weighted according to population.
Because CPI is used to measure inflation, it also helps to set inflationary
expectations (inflation will often end up being what people expect it
will be, because people act on their expectations, and “make inflation
happen”.
The CPI is not a “cost of living” index, although it’s used as one. It does
not measure consumer satisfaction or standard of living.
There is no attempt to exclude luxuries, which would not be bough by
poorer families, nor is there any attempt to exclude what some people
would consider morally or socially unacceptable products, such as
tobacco and alcohol.
Alternative measures of inflation
Producer’s Price Index
Building and Construction Index
Farm Expenses Price Index
Food Index
CAUSES OF INFLATION
Causes of inflation can be categorized as demand-pull inflation, where
the demand for goods and services outstrips the ability of the economy to
make them, or cost-push inflation , where the costs of inputs drives prices
higher as producers try to recoup their increased costs.
Demand-Pull Causes
The classic description of this type of inflation is “too much money chasing
too few goods”. Typically, it occurs when the economy is trying to operate
beyond its capacity. There are shortages of labour and materials, and
“bottlenecks” occur in industries, causing major delays. Once an
inflationary gap occurs, the actual level of GDP, which cannot go past
economic capacity (PPF), cannot reach equilibrium.
A budget deficit If a government runs a budget deficit, it must borrow the
money it needs to pay for extra spending that it is not financing through
taxation. If it borrows internally (i.e. from New Zealanders), there will be no
appreciable change in either aggregate demand or aggregate supply,
but if it borrows overseas this may provide an injection to the circular flow,
which increases inflation. Aggregate demand will rise.
Approaching economic capacity As the economy approaches full
employment, there can be labour and capital shortages. There is a
shortage of labour because not everyone can do all jobs. Producers of
capital goods may not be able to cope with demand and find they can
increase prices.
Inflationary expectations People often act on “what they believe will
happen in the future”. If people believe prices will rise in the future, they
will buy now, even if it means buying on credit, since they expect the
interest rate to be offset by inflation. By doing so, aggregate demand
rises, and so does the general level of prices. Expectations tend to
become self-fulfilling prophecies.
Cost-Push Inflation
Inflation can be caused when an economy experiences an increase in
costs which affects a significant portion of the economy. These increases
may be caused by a permanent rise in imported oil or a rise in wages.
The Wage/Price Spiral – Money wages would rise, but real wages would
remain the same. This causes the following spiral, which results in inflation
rising rapidly.
An increase in
costs
An
increase in
AD
An
increase in
inflation
The demand for more
money to fund the
increase in wages
An increase in
wages – AS rises
Increase in costs of production If wages or some other significant factor
income or cost of production rises, this can cause the aggregate supply
curve to move upwards and inwards.
Overseas prices This is also known as “imported inflation”. If there is a
significant increase in import prices, this can either increase aggregate
demand or aggregate supply, or both, also occasionally contributing to
demand pull inflation.
The Money Supply and the Rate of Inflation
For the wage/price spiral to operate, there has to be an increase in the
money supply to allow employees to receive their new wage rises.
Without this extra money, employees could not spend their increased
wages.
The Fisher’s Equation
MXV=PXQ
M – The volume of money in the economy
V – The velocity of circulation, how many times notes and coins will
change hands in the economy or how fast people can make the money
go around.
P – The general level of prices in the economy
Q – The number of transactions, the number of times money is used to buy
goods and services, i.e GDP.
Q (representing GDP) and V (the velocity of circulation) are constant. If
this is true, then an increase in the money supply would lead directly to an
increase in the price level.
The money supply in New Zealand
Money can be used to buy things – the transactions motive. Sometimes it
can be kept in the bank until needed to be accessed by and EFPOS card
or cheque. To take account of what money is available to spend at what
time, the Reserve Bank has a series of definitions.
M1 – includes notes and coins held by the public, plus chequeable
deposits. This includes EFTPOS accounts if they are also cheque
accounts
M2 – Consists of M1 plus all call funding (includes overnight, money and
funding on terms that can of right be broken without break penalties).
This also includes EFTPOS accounts that are not cheque accounts.
M3 – This is the broadest money aggregate. It includes everything
classified as M1 or M2, plus all term deposits (minus any government
deposits and anything the banks lend to each other)
M3(R) – Resident M3 aggregate. Represents New Zealand dollar
funding from New Zealand residents only.
EFFECTS OF INFLATION
Inflation warps the economic signals in an economy. False signals give
incorrect information, so resources end up being misallocated.
Poor planning for the future
Inflation makes business and government planning very difficult. There is
no such thing as stable high inflation. A great deal of time and highlyeducated effort is needed to correctly estimate the rate of inflation at a
future date, and to then implement the necessary price and cost
changes into current and medium-term planning.
Negative effect on investment and growth
The cost in loss of profits for any business which incorrectly guesses the
future rate of inflation can be very high. It is better to “play it safe”, not
guess at all, and react to inflation as it occurs. The opportunity cost of this
attitude to inflation is usually no long-term planning, and no long-term
investment.
Interaction with the tax system
As money incomes rise, under a system of progressive taxation, the
percentage of income taken in tax also rises. If nominal wages are rising
only in response to rising prices, then a progressive tax can make
households worse off. In times of inflation, producers find difficulty in
keeping up with taxation changes.
Impact of inflation of employment
If wages are permitted to rise every time there is a rise in the general level
of prices (the wage price spiral is operating), those who remain in work will
experience little change in their standard of living. However, even if real
wages remain virtually constant, money wages are rising, and this may
cause some producers to think twice before replacing staff who have left.
The number of job vacancies can fall, particularly if the inflation has been
caused by cost-push factors.
If real wages rise in relation to the costs of other factors such as capital,
this can lead to a substitution of capital for labour.
If inflation has been caused by demand-pull factors, producers will be
experimenting buoyant conditions, and will try to compete with other
producers for staff. In this case, demand often exceeds supply, nominal
wages are increasing due to competition for particular types of labour,
and there may be a demand for migrant labour.
When the economy is in an inflationary boom period, there may be
political pressure on the government to open the door to migrant labour
to fill the jobs that New Zealanders ‘prefer to leave vacant’. In the past,
these have tended to be the low-skilled jobs. Problems occur when the
boom passes. Supply exceeds demand, and the new migrants, instead of
being welcomed, are now looked down on as the ‘cause’ of the current
unemployment.
Inflation and growth
**
Inflation and income distribution
When inflation is low, little income redistribution can be attributed to
inflationary pressures but more to changes in employment patterns,
welfare dependency and training.
In times of inflation, those on fixed incomes are penalized as they cannot
keep pace with money incomes and experience a drop in purchasing
power. Consequently, these people become poorer and poorer as their
incomes remain the same.
Some households can benefit from inflation if the main source of their
income is from speculative rather than productive sources. If a speculator
can buy and sell ‘inflation-proof’ assets (e.g. real estate), or assets which
perform better in times of inflation, inflation can reward the speculator at
the expense of the producer.
Income, which is the return to factors of production, should send signals to
the market showing which factors are in demand. Inflation muddles these
signals, and redistributes the resources.
The impact of inflation on households
Inflation cuts savings
If interest rates are less than the rate of inflation, the value of savings falls.
Over a period of inflation, the purchasing power of this savings falls.
Money saved at times when money bought more but now ends up
buying less, discourages saving. When individuals in an economy would
rather buy “inflation-proof” assets such as antiques rather than save
money, this inhibits economic growth. Less savings leads to less money
being available to buy new capital.
Inflation hurts lenders
Money lent on fixed interest at times of inflation becomes worth less and
less as the term of the loan continues. Both principal and interest were
worth more at the start of the loan than at the end.
CONTROLLING INFLATION
The main tools the government has open to it to control inflation, or to
minimize the impact of it are
Direct controls
Fiscal policy
Monetary policy
Fiscal policy
Fiscal policy is the tool which government can use to control the
economy through its spending and the way it raises its tax revenue. If
taxation coming out of the circular flow exceeds government spending
going into the circular flow, the effect is anti-inflationary. Surplus budgets
are anti-inflationary, while deficit budgets promote inflation.
With the passing of the Fiscal Responsibility Act 1994, the government is
obliged to produce a transparent, financially responsible budget.
Government tightens fiscal policy
Presents a budget which either increases a
surplus or reduces a deficit.
Taxes increased: income tax
increases, GST increases, fees
and charges increased
Expenditure decreased:
defence, education etc, SOEs
sold off, public servants laid off
Reduced incomes for consumers and suppliers
Reduced spending by consumers, reduced income/profit of producers
Reduced demand for goods and services, inflation rate falls
Monetary policy
Monetary policy is the tool used by the government to control the
economy by controlling money and the banking system. This is the main
tool of the government to control inflation. The Reserve Bank Act 1989,
makes price stability the sole aim of the Reserve Bank, which is charged
with keeping inflation under control.
The Reserve Bank of New Zealand
This is New Zealand’s central bank. The job of a central bank is to control
the banking and finance sector in an economy. The Governor of the
Reserve Bank is held personally accountable for the performance of the
Reserve Bank.
Promoting the
maintenance of a sound
and efficient financial
system
Main functions of the
Reserve Bank
Meeting the currency
needs of the public
Operating monetary
policy to achieve
price stability
Policy Targets Agreement
The Reserve Bank Act 1989 requires the definition of price stability to be
public knowledge. A Policy Targets Agreement is a contract between the
government and the Governor of the Reserve Bank, containing the
current definition of inflation.
Following the 2002 election, the PTA was amended to define price stability
as an average of 1-3% increase in prices over the medium term as
measured by the CPI.
Official Cash Rate
In order to control inflation, the Reserve Bank sets the basic interest rate
ruling in New Zealand. This is called the Official Cash Rate. The Reserve
Bank estimates what inflation will be over the next year or two, then sets
the OCR at a rate which will keep the CPI within 1-3%. To do this
forecasting, the Reserve Bank uses economic indicators. The OCR
influences short-term interest rates (such as the 90-day bill market).
The Reserve Bank will pay financial institutions 0.25% less than the OCR for
money they deposit with the Reserve Bank, and charge them 0.25% more
than the OCR for any money they borrow from the Reserve Bank
overnight.