ECON1002

Introductory Macroeconomics
Week 2 Lecture

Semester 1, 2022
School of Economics

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 Lecture 2:
Measuring the price level and inflation, Savings and Investment

At the end of this lecture, you should be able to answer the

following questions:
 How is the CPI (and inflation) calculated?
 What are the economic costs of inflation?
 Do I understand the distinction between the nominal
and real rate of interest?
 Why do people save?
 What is the link between savings and wealth?
 What is national saving and how is it related to
Investment?
Reading: Textbook Chapters 3 and 4.
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 Measures of the price level

 We already saw how an aggregate price level can be

measured in Week 1. Recall “GDP Deflator”!
 But, consumption by individuals (or households) is important for
economic welfare.
 Policy-makers are interested in measures of the overall cost of
living for households and how that changes over time.
 The Consumer Price Index: is used to measure the change,
over time, in the cost of purchasing a fixed basket of goods
and services by typical households.
 The CPI is used to calculate the increase (or decrease) in
prices (i.e., the rate of inflation) over a particular period.

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 Australia’s Consumer Price Index
Weighted average of eight capital cities
Sep 2021 to Dec 2021 Dec 2020 to Dec 2021
% change % change
The CPI measures All groups CPI 1.3 3.5
Food and non-alcoholic beverages 0.7 1.9
changes in the price
Alcohol and tobacco 0.9 1.1
of a ‘basket’ of goods Clothing and footwear 2.6 -0.3
and services which Housing 1.8 4.0
account for a high Furnishings, household equipment and services 1.1 3.6
proportion of Health -0.3 3.3
expenditure by the Transport 2.8 12.5
CPI population group Communication 0.1 -0.5
(i.e., metropolitan Recreation and culture 1.5 2.1
Education 0.1 0.6
households) over a
Insurance and financial services 1.2 2.2
given period.
CPI analytical series
All groups CPI, seasonally adjusted 1.3 3.7
Trimmed mean 1.0 2.6

Source: Australian Bureau of Statistics, Consumer Price Index, Australia December 2021
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 The Consumer Price Index
Example 1: Percentage Price Change
Assume a household only consuming movie, burger and electricity.
In 2017, the total weekly expenditure was (1 x $16) + (2 x $12) + (84 x $4.5) =
$418. Consider prices changes as below in 2018. What’s overall price change?

(84 × 4.50/418)×5.556%+ (2 × 12.00/418)×4.167% + (1 × 16/418)×6.250% = 5.502%.

Why? Used the same expenditure weights as 2017.
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 The Consumer Price Index
Example 2: Consider the following expenditures (Costs in $)

To calculate a cost of living (or consumer price index) we simply

divide the cost of the basket in the current year by its cost in the
base year. The CPI in the base year is 1 (or set for 100).
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 The Consumer Price Index
Quarterly CPI data

2015 CPI How do we interpret the data?

Mar 171.0 Suppose a family needed an average of
Jun 172.1 $174.0 a day for living in Dec 2015.
Sep 173.3
This family would need $179.40 a day for
Dec 174.0 living in Dec 2016.
2016 CPI
Mar 176.7 This assumes (i) expenditure weights
Jun 178.3 unchanged and (ii) quality unchanged.
Sep 179.4 CPI is a fixed weight price index, which is
Dec 179.4 a Laspeyres index.

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 The CPI and Inflation
How do we calculate?
CPI Jun − CPI Mar
1) Quarterly inflation, e.g. from Mar qtr to Jun qtr = ×100(%)
CPI Mar

What was the quarterly inflation from Mar to Jun qtr in 2016 from the
table in previous slide?

2) Four quarter (Year)-ended inflation, e.g. from Dec qtr 2016 to Dec qtr
2016
CPI Dec ,2016 − CPI Dec ,2015
= ×100(%)
CPI Dec ,2015

What was the year-ended inflation from Dec Qtr 2015 to Dec Qtr
2016 from the table in previous slide?
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 Australia’s CPI Inflation

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 Headline vs Underlying Inflation

What is
‘underlying’
inflation and
what is
‘headline’
inflation?

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 The CPI and Inflation
Australia’s Inflation Experience

CPI Inflation: 1960-2008

% per annum

18

16
The Great Inflation
14

12

10

6
GST
4

-2
Mar-1963 Mar-1968 Mar-1973 Mar-1978 Mar-1983 Mar-1988 Mar-1993 Mar-1998 Mar-2003 Mar-2008
Data source: DX, ABS
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 CPI inflation and the cost of living
Limitations of the CPI based inflation
The CPI inflation is a biased (often overstated) measure of the true change in the
cost of living! Why?

 Substitution bias: Do we always consume a fixed basket?:

Underestimates the possibility of consumption substitution. Relative
prices change all the time.
 Quality bias: Is the quality of the market basket constant over time?
The quality of goods usually improves over time.
 Heterogeneous preference: Do Retired and DINKs (double income no
kids) have the same consumption preferences?
 Not all new goods and services are accounted for. Do households buy
everything that the economy makes? Some goods are not freely supplied
and we cannot choose (i.e. hospital beds and medicines)
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 The Costs of High Inflation

 Inflation erodes the purchasing power of money. In general,

loss of confidence, uncertainty, efficiency costs. It’s like a tax!

 Costs of real resources (e.g. ‘Menu’ costs, ‘Shoe-leather’ costs)

– costs associated with economising on money.

 Adverse effects on incentives: ‘unearned’ redistributions of

wealth. Loans and wages typically in Nominal contracts.

 Noise in the price system: distorts price signals. Causes

confusion between relative prices versus general price level.

 Distortions of the tax system. Higher effective tax rates due

to ‘bracket creep’ in a progressive tax system.
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 Why is inflation like a tax?
 Can a family buy more with $40 000 in income in 2015 or with
$44 000 in 2018?
– 2015 is the base year for the CPI
– Deflate nominal income in both years to get real income
– Compare real income
– $40 000 in 2015 has the greater purchasing power

Year Nominal income CPI Real income

2015 $40 000 1.00 $40 000/1.00 = $40 000
2018 $44 000 1.25 $44 000/1.25 = $35 200

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 Very High (Hyper) Inflation?
You may need a $100 Bil to buy a burger!

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 Adjusting for inflation

 A nominal quantity is measured in terms of its current dollar

value.
 A real quantity is measured in physical terms (e.g. quantities
of goods and services).
 Deflating
 CPI is used to convert (nominal) quantities measured at
current values into real terms.
 Indexing
 CPI is used to keep real values or quantities constant, e.g.
CPI indexation of unemployment benefits or pensions.

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 The Costs of Inflation
Can government take away more money than you ever realise?

Inflation creates ‘bracket creep’ in a progressive, non-indexed tax

system. Consider the following tax scale (Australia in 2005-06)

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 The Costs of Inflation

Consider a 10 percent increase inflation and your

nominal income. What happened to your real income?
How much tax do you pay now? Why?

So, you are actually made worse off due to inflation and a
non-indexed progressive tax system!

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 The Costs of Inflation Why Indexation?
 Indexing increases a nominal quantity each period by the percentage
increase in a specified price index.
 Indexing prevents the purchasing power of the nominal quantity
from being eroded by inflation.
 Indexing automatically adjusts certain values, such as social welfare
payments, by the amount of inflation.
 If prices increase 20% in a given year, social welfare recipients
receive 20% more.
 No action by the government is required.
 Indexing is sometimes included in employment contracts (see next
slide).
 For a debate on indexation, see this video (between 5 and 10
min), [Link]
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 Inflation and Interest rates
Nominal contract and expectation

 Borrowing and lending contracts specify how much

money will be paid back to the lender at a given time.
 The higher the rate of inflation over the contract period,
the more the lender is penalised through a fall in the
purchasing power of the money lent. Why?
 So a rise in the expected inflation rate raises the rate of
interest which lenders demand.

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 Inflation and interest rates

Scenario 1: Inflation = 0

Scenario 2: Inflation = 5%

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 Inflation and interest rates

Scenario 3: Inflation Adjusted Loan Contract

Interest Rate = Real Return (Real Interest Rate) + Inflation

i= r +π
r= i −π
This is called the Fisher Equation
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 Inflation and interest rates

 The nominal interest rate is the rate of interest specified in

the loan contract.

 The real rate of interest is the nominal rate of interest

minus the rate of inflation.

 It measures the reward to lenders, in terms of purchasing

power, paid by borrowers for lenders giving up spending
over the contract period.

 Unanticipated inflation makes creditors worse off!

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 Deflation

 Deflation is a sustained fall in the average price

level.
 Problem: It can lead to high real interest rates, and high
real interest rates discourage important expenditure
types such as a firm’s investment in plant and equipment.

 This is due to the fact that the nominal interest rate

must be above 0% or loans would not be made.
 Why would you loan money out, just to get the same
amount of money back?

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 Deflation and Real interest rate
 Suppose that the expected real interest rate is 2%.

 Real interest rate (r) = Nominal interest rate (i) – inflation rate (π).
If the inflation rate is: Expect a nominal interest rate of:
0% 2%
–2% 0%
–3% –1%

 But no-one would make loans at nominal interest rates of 0% (zero

lower-bound) and below. This implies that deflation rates of –2%
and below cause the real interest rate to rise.

 - 3% inflation would mean real interest rates of 3% or more!

Why? r = 0 – (-3) = 3%!
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 Deflation in Japan

Deflationary period

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 Inflation, Deflation & Interest Rates

With positive inflation

– Nominal interest adjusts upwards as inflation increases
leaving the real cost of borrowing unchanged

With negative inflation (deflation)

– Nominal interest adjusts downwards until they reach
the lower limit of 0% - thereafter, the real cost of
borrowing increases as the deflation worsens.

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 Savings and Wealth

“If you would be wealthy, think of saving as well as getting”.

Benjamin Franklin
US author, diplomat, inventor, physicist, politician, & printer (1706 - 1790)

Saving: current income minus Wealth: value of assets minus

spending on current needs value of liabilities

N.B. Paying rents consumption, but

Paying off mortgage saving. Confused?

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 Savings and Wealth

Saving: current income minus Wealth: value of assets

spending on current needs and minus value of liabilities
is a Flow. and is a Stock.

Economic examples

Flow Flows Stocks

Investment Capital
Income, expenditure Wealth
Workers fired/hired Unemployment
Budget deficit Public Debt
Household deficit Credit card balance
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 Household Savings in Australia

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 Factors affecting household savings

 The age pension and national superannuation reduce the need

to save for retirement
 Note that superannuation levies raise business saving at the
expense of household saving
 Capital gains in share and real estate markets increase
perceptions of wealth and the perceived need to save for
retirement.
 Falling unemployment and prosperity reduce the perceived
need for precautionary saving.
 Why did the GFC and Covid pandemic induce households to
save more?

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 Why save?

 Life Cycle theory

 Need for drawing on wealth varies over
individuals’ life-cycles

 Precautionary Saving
 Saving for a rainy day

 Bequest saving
 Saving for one’s children

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 National savings

National income Y = C + I + G + NX

Assuming net exports (NX) = 0 Y=C+I+G

By definition, national savings S = Y – (C + G)

Substitute out Y to write S = C + I + G – (C + G)

A nation’s capacity to invest depends on

savings, unless it borrows from foreign S=I
savers!

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 National savings

S = Y – (C + G)

Subtract and Add T (net taxes)

T > G = budget surplus

S = (Y – T – C) + (T – G) T < G = budget deficit

Private sector Government

savings savings
(household & (budget
business) deficit/surplus)

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 Investment decision

 Firms’ investment is the second largest component of

national income.

 What factors determine whether and how much

firms choose to invest?

 The investment decision is made based on the cost–

benefit principle.
 Marginal Benefit of investment ≥ Marginal Cost
of investment

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 Investment

What are the Costs? What are the Benefits?

(1) Real interest rate Produce more output

Opportunity cost  ∆Q 
↑ MPK  or 
 ∆K 
(2) price of capital
Marginal Product
equipment (gains/losses) of Capital

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 Determinants of the level of investment

 Real interest rate

 If the interest rate increases to 12% instead of 6%,
his interest expense is $480 which exceeds the $400
marginal product.
 Taxation rate
 If taxes increase to 25% on net revenue, his marginal
product of $100 is exceeded by the $240 interest
expense.
 Other impacts on revenues
 If the running costs are different from those expected,
or the price he can charge for his service changes,
these facts will impact on the costs and benefits that
determine the value of the marginal product.

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 Determinants of the level of investment

 Even if a firm finances capital from its savings,

the real interest rate is an opportunity cost of
alternative uses of its finance.
 Increased real interest rates increase the
opportunity cost.

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 Savings and Investment
A Theory of Determinants of Investment

Investment function Shifts in investment

r r

$ $

↑ P and/or ↑ Pr oductivity
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 Savings and Investment
Equilibrium

Savings function S & I Equilibrium

r r

$ $

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 Savings and Investment
Technology/productivity

r
How does a new
technology affect
investment by firms?

$
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 Savings and Investment
Government Saving/Deficit

An increase in the Budget deficit (ceteris paribus)

An increase in
government budget
deficit tends to
‘crowd out’ private
investment. (why?)

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