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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.