Inflation — Flashcards & Quiz

Q1: What is inflation and how is it measured using the Consumer Price Index?

Inflation is the sustained increase in the general price level of goods and services over time, reducing the purchasing power of money. It is measured by the Consumer Price Index (CPI), which tracks price changes in a basket of goods and services representing average household expenditure. The Australian Bureau of Statistics (ABS) surveys prices quarterly across categories including housing, food, transport, health, and recreation. The inflation rate is the percentage change in CPI over a period. The Reserve Bank of Australia (RBA) targets inflation of 2-3% annually, considered optimal for economic stability and growth.

Q2: What are the main causes of inflation: demand-pull and cost-push?

Demand-pull inflation occurs when aggregate demand exceeds the economy's productive capacity, causing prices to rise as consumers compete for limited goods and services. Caused by: excessive monetary growth (low interest rates), fiscal stimulus (government spending), strong consumer/business confidence, or export booms. Cost-push inflation occurs when production costs increase, forcing businesses to raise prices to maintain profit margins. Causes include: wage increases exceeding productivity, higher imported input prices (oil, components), supply shocks (droughts, natural disasters), or exchange rate depreciation raising import costs. Built-in inflation results from expectations: workers demand higher wages to compensate for expected inflation, creating a wage-price spiral.

Q3: What are the economic effects and costs of high inflation?

High inflation causes: reduced purchasing power eroding real incomes and living standards; redistribution from creditors to debtors (debts repaid in devalued currency); distortion of resource allocation as price signals become unclear; reduced international competitiveness as domestic prices rise faster than trading partners; uncertainty reducing business investment; bracket creep pushing workers into higher tax brackets without real income gains; and menu costs (frequent price changes). Deflation (falling prices) is also problematic, causing deferred spending, increased real debt burdens, and potential recession. The optimal inflation rate is 2-3%, providing price stability while avoiding deflation risks.

Q1: The Reserve Bank of Australia targets an inflation rate of 2-3% per year.

Answer: TRUE

The RBA's monetary policy framework targets inflation between 2-3% over the economic cycle, considered optimal for price stability while allowing flexibility for economic adjustment. Rates above 3% risk damaging effects, while below 2% raises deflation risks.

Q2: Demand-pull inflation occurs when production costs increase, forcing businesses to raise prices.

Answer: FALSE

Cost-push inflation occurs when production costs rise. Demand-pull inflation occurs when aggregate demand exceeds productive capacity, causing prices to rise as consumers compete for limited goods. They have different causes and require different policy responses.

Q3: High inflation redistributes wealth from creditors (lenders) to debtors (borrowers).

Answer: TRUE

Inflation erodes the real value of money, meaning debts are repaid in currency worth less than when borrowed. This transfers real wealth from lenders (who receive devalued repayments) to borrowers (who repay with cheaper money), particularly harming savers and fixed-income earners.