Macroeconomics Questions/Answers - Assignment Solution

What are the costs of price instability? Include in your answer a real-world example and calculations of consumer price index (CPI) and inflation rate.

When investigating a country’s financial status there are two points which will be examined, one of which is Price Instability, which refers to a short-term disequilibrium in the buying and selling relationship in a market causing hyper-inflation and/or food price dramatic rise. The second factor is the Consumer Price Index (CPI), which measures changes in the price level of consumer goods and services purchased by households in an economy. It is a statistical estimate derived by using prices of a sample of representative items whose prices are collected periodically. 

The two above mentioned factors will determine a country’s policies in tackling inflationary rate, however the CPI measurements represents price levels increase over a period of time, which indicates the purchasing power and value of a nation’s currency.

In most instances, inflation generally takes place when a country produces above potential output unemployment falls below natural rate. This often results in significant rises in the cost of living, wages remaining low and the value of currency in decline.

The significant consequences of inflation will be seen in the following areas:

1. Greater uncertainty resulting in firms postponing investments due to the volatile market, which slows down the economic growth. Savings are also affected, as more funds are required to sustain consistent level.
2. Damage to exports competitiveness also results from high inflation rates as the cost of production will rise and the export goods become less competitive on the international market which in turn results in an adverse effect of the balance of payment. 
3. Interest rates are significantly affected by inflation, and if not controlled, households and businesses spending will fall drastically, resulting in high numbers of loan defaults and business closures. 

The diagram above illustrates price instability as seen for example in Zimbabwe in recent years.

Political instability or unstable national output causes the prices to inflate (consistent and durable CPI increase over a period of time) from P1 to P2, and lower the value of the currency thus lower purchasing power of households. This causes an increase in demand for currency as shown between D1 and D2.

In parallel the supply of money drops due to ongoing economic crisis from S1 to S2.

The equilibrium will move to E1 to E2 and quantity of money available / demanded by the market will fall from Q1 to Q2. 

The hyperinflation seen in Zimbabwe has roots beginning in the late 90s with the confiscation of private farm from landowners, since then prices have been doubling daily.  This is fuelled by the government printing money in response to high national debt (thus more money in circulation), the decline in economic output and exports earnings, increased price control and lack of confidence the government.

Therefore, this means people couldn’t afford basic goods due to the prices increasing exponentially, no credit is available, switching to barter economy and trading in US dollars and lost savings. 

In Australia the RBA has a significant role in monitoring the domestic and international financial stage, inflationary triggers and adjusts interest rates to ward or minimise potential inflationary effects as a result of external influences and to stimulate the economy. The RBA stimulus is undertaken to improve business confidence in the economy, stabilise monetary value, promote growth and international competitiveness.

To conclude it is clear a government should stringently monitor its spending and the CPI levels. Failing to do so would be adding a risk of significant rise in cost of living expenses for household’s (and higher unemployment as a consequence) with potential for international debt ballooning out of control leading to exorbitant interest rates, decrease in currency value, social unrest and a struggling economy.