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Week 9 Tutorial Activity ECON1246 / ECON1273Macroeconomics 1 Assessment 2 Part 2 MACROECONOMICS 1 (ECON1246 ECON1273) Assessment 2 Part 2 This assignment covers the following topics: · Inflation – Topic 5 · Labour Force and unemployment – Topic 6 · Foreign exchange rate market – Topic 7 READ THE FOLLOWING FIRST · Explain your answers, but be succinct (brief and relevant). Show all of your working in order to get partial credits. · Show you CULCULATION under each question. To make sure you have a good understanding. SECTION A 14 marks The economy of Euphoria has the following economic data. Year 2015 2016 2017 Nominal Gross Domestic Product ($ billions) 470 485 545 Real Gross Domestic Product ($ billions) 470 480 505 % change in real Consumption spending 3.00 1.25 1.00 % change in real Investment spending 2.00 -10.00 5.00 Net exports ($ billions) - 23,000 - 52,000 - 5,000 Unemployment rate (%) 5.3 5.8 6 Natural rate of unemployment 4.8 4.8 5.4 Index of production costs (2015 = 100) 100 105 107 Productivity index (2015 = 100) 100 101 103 Examine the data relating to the economy of Euphoria above and answer the following questions. Q1 a. Calculate the real growth rate for 2016 and 2017 to two decimal places. b. Calculate the inflation rate for 2016 and 2017 to two decimal places. c. What phase of the business cycle was the economy in 2016 and 2017? Briefly give two reasons for your answer. (1 + 1 + 2 = 4 marks) Q2. What was the likely cause of the change in the unemployment rate in 2017? What type of unemployment is likely to exist in Euphoria in 2017? Explain your answer. (3 marks) Q3. Identify and explain the likely cause of inflation in 2017? (4 marks) Q4. Read the article ‘Venezuela Cuts to Fight Inflation (Zeros from Its Currency. That Is)’ a. Identify and briefly explain the two causes of hyperinflation in Venezuela. b. Illustrate these using the AD-AS diagram clearly showing the increase in the inflation rate. (3 marks) 1 1 Assessment 2 Part 2Semester 2 2018 Slide 1 Vocational Business Education Slide 1 Topic 5: Measurements of inflation Textbook reading: Chapter 8 pp203-212, pp214-215 (Causes of inflation) Measurements of Inflation Learning Objectives: Define inflation, inflation rate, price level and Consumer Price Index (CPI). Calculate the inflation rate. Name and briefly explain the various ways of measuring inflation. Explain the sources of bias in the CPI Distinguish between the CPI & the GDP Deflator Distinguish between nominal and real variables Calculate the purchasing power of the dollar in different years. Explain the difference between demand-pull & cost-push inflation Vocational Business Education Slide 2 Vocational Business Education Slide 3 Inflation Inflation: refers to a sustained increase in the general level of prices in the economy. Deflation? …a sustained decrease in price levels. Price level: a measure of the average prices of goods and services in the economy. Inflation rate: percentage increase in the price level (price index) from one year to the next. 3 3 Measurements of Inflation At least 3 ways of measuring inflation: 1. Consumer Price Index (CPI). Measures the inflation rate on common household goods & services. 2. GDP Deflator. It is a broad measure of the price level; it measures the change in prices of all goods and services that make up the GDP. 3. Producer Price Index (PPI). Measures the inflation rate on producer goods & services. Vocational Business Education Slide 4 - Producer Price Index won’t be examined in this course, it is purely mentioned for completeness sense. - GDP deflator was examined in topic 2 Measurements of Gross Domestic Product 4 Vocational Business Education Slide 5 Measurements of Inflation – Consumer Price Index 1. Consumer price index (CPI): A measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities. The Market Basket: In Australia, the Australian Bureau of Statistics identifies: A typical or representative Australian household. The goods and services purchased by the household – this is the “market basket”. The prices of goods and services in the market basket are given a weight according to their fraction of a ‘typical’ family budget. The CPI measures the rate of change in the prices of the goods and services in the market basket. Most widely used measure inflation Often mistaken for the only measure of inflation. What’s in the CPI’s basket? Copyright©2004 South-Western 6 16th series CPI, June quarter 2011, weighted average of eight capital cities Vocational Business Education 6 Figure 6.1: The CPI market basket. Source: Australian Bureau of Statistics (2016), Consumer Price Index 16th Weighting Pattern, Cat. No. 6430.0, Table 1, Percentage contribution to all groups, CPI, June quarter, eight capital cities. Goods and services in the CPI market basket are grouped into 11 broad categories. Almost half of the market basket falls into the categories of housing, transportation and food. How the CPI is calculated Computing the inflation rate: the inflation rate is the percentage change in the price index from the preceding period. The inflation rate is calculated as follows: Vocational Business Education Slide 7 Vocational Business Education Slide 8 Calculating the CPI – an example Assume the consumer price index is based on the change in prices of a given basket of goods consisting only of 4 apples and 2 burgers. Calculate 1. the cost of the basket for 2014, 2015 and 2016, 2. the CPI for each of the 3 years, 3. inflation rate for 2015 and 2016. Fixed basket of 4 apples and 2 burgers YearPrice of applesPrice of burgers 2014$1$5 2015$1.50$4.50 2016$3$4 YearCost of basket 2014 2015 2016 YearConsumer price index (2014 is the base year) 2014PI = current year cost / base year cost x 100. 2015 2016 8 8 9 Problems in measuring the cost of living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Problems substitution bias introduction of new goods unmeasured quality changes The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. Vocational Business Education Slide 9 10 Substitution bias The basket does not change to reflect consumer reaction to changes in relative prices. Fixed line vs mobile phones - Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. Vocational Business Education Slide 10 11 Introduction of new goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable - Consumers need fewer dollars to maintain any given standard of living. Unmeasured quality changes A new DVD player If the quality of a good rises (falls) from one year to the next, the value of a dollar rises (falls), even if the price of the good stays the same. Vocational Business Education Slide 11 12 ABS price indexes In addition to the consumer price index for the overall economy, the ABS calculates several other price indexes. GDP Deflator: Measures the change in prices of all goods and services that make up the GDP. Calculated by dividing nominal GDP by real GDP and multiplying by 100: Producer price index, which measures the cost of a basket of goods and services bought by firms rather than by consumers. Vocational Business Education Slide 12 The GDP deflator versus the CPI First, the GDP deflator reflects the prices of all goods and services produced domestically, whereas ... … the consumer price index reflects the prices of all goods and services bought by consumers. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. Second, the consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year... … whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. 13 Vocational Business Education 13 Vocational Business Education Slide 14 Measurements of Inflation - Comparison GDP DeflatorConsumer Price Index All domestic goods and services; includes C, I G1, G2 and XGoods and services bought by consumers; only C & G1 Domestically produced goods and services; includes exportsDomestically and internationally produced goods and services; includes imports Variable quantity of goods and servicesFixed quantity of goods and services 14 14 Uses of inflation CPI is used widely in: Comparing purchasing power of the dollar between periods, i.e. comparing the cost of supermarket shopping between years. Deciding on the most profitable investment by using the real rate of interest and not the nominal interest rate. Negotiating pay rises, i.e. nominal vs real wages. Based on the expected CPI for the next period, employers and employees negotiate pay rises. Indexing pensions, i.e., Many pensions are indexed to the CPI so that pensions will increase according to the CPI. Vocational Business Education Slide 15 Purchasing power of dollar Price indexes, such as the CPI, allow us to adjust for the effects of inflation so we can compare dollar values of time. To change dollar values from one year to the next, we can use this formula: Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. Phar Lap (a famous horse) had winnings of $19,000 in 1930. How much is it in 2016 dollars? Vocational Business Education Slide 16 17 Correcting economic variables / Comparing purchasing power of the dollar Winnings in 2016 dollars = winnings in 1930 dollars × (price level in 2007/price level in 1930) From the ABS statistics the CPI in 2016 was 194.4, and in 1930 it was 4.7 $19,000 × (194.4/4.7) = $785,872 Vocational Business Education Slide 17 Interest represents a payment in the future for a transfer of money in the past. The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for the effects of inflation. If the inflation rate is higher than expected, borrowers may gain and lenders receive a lower real interest rate (on a fixed interest rate loan). The real interest rate provides a better measure of the true cost