Inflation, Balance of Payment and Monetary Policy

What is the main measure of inflation movements in Australia and what does it represent?

CPI refers to the Consumer Price Index and is used as the primary measure of inflation movements within Australia over time. CPI can be defined as a measure of how the prices of goods and services change over time. It is a measure of overall cost a typical consumer pays for the purchase of goods and services. A larger increase in CPI represents an inflationary trend in the economy and decrease in CPI shows deflationary situation. It also helps in comparing the inflation patterns with other countries of the world.
CPI can be calculated using the following formula:

Inflation refers to the persistent rise in the general price level in the economy. Rising inflation negatively affects the purchasing power of a typical consumer, therefore, a typical family has to spend more to maintain his existing standard of living. We can estimate the rate of inflation in the following way:

Where:
refers to Inflation rate in the current financial year.
refers to CPI in the preceding financial year.
refers to CPI in the current financial year.
CPI is considered as a benchmark inflation guide for the Australian economy

The balance of payment is a record of monetary transactions between Australia and the rest of the world- it is made up of two accounts. What are the names of the accounts and what do they measure?

Balance of payment keeps track of inflow and outflow of money from the economy of a country. It consist of two main accounts:-

Current Account
Capital Account

Current Account

The current account measures trade flow in and out of the country. In other words, it represents country’s exports and imports. It consist of following three components.

Trade in goods and services
Net Foreign Income
Current Tranfer/Foreign aid

Trade in Goods and Services

The most important component of the current accounts is the balance of trade showing the country’s imports and exports of goods and services. If exports are larger than imports, it is a balance of trade surplus and if exports are fewer than imports shows a balance of trade deficit.

Net foreign Income

If local companies or individuals of a country (let say Australia) purchase bonds and stocks in other countries, the money will come into the country in the form of interest and dividend payments and will add to the net foreign income. On the other hand, the money that leaves the country in the form of interest payments and dividends to foreign investors, royalties paid by the subsidiaries (located in Australia) to their overseas head offices decreases the total net foreign income.

Current transfer / Foreign Aid

Grants/ donation and workers (foreigners) send money to their home countries.
Current Account Surplus and Deficit
Current account surplus means that country is earning more than spending or in other incoming money (credits) exceeds outgoing money (debit). It means the country has more money to lend to other countries. Whereas, the current account deficit shows that the spendings of a country are higher than income/earnings.

Capital Account

It tracks the movements of funds for investment into and out of the country the capital account consist of four main components such as:

Direct investment:
Portfolio Investment
Government Capital
Official Reserve

Direct investment:

It refers to the foreign direct investment when the investor acquires ownership and control over these assets.

Portfolio Investment

It represents money that flows into and out of the country for the purchase of financial assets like stocks and bonds, whereas, the payment of the dividends and interest from these foreign investments will be the part of the current account and will not be counted towards capital account.

Government Capital

It refers to the Government borrowing from and repayments to overseas countries.

Official Reserve

The net foreign exchange transactions of central banks.
Capital Account Surplus and Deficit
The capital account surplus means more inflow of foreign capital into the country in the form of investments and the capital account deficit shows outflow of foreign capital from the country for investments compared to the domestic investment.
A capital account surplus is usually being balanced by the current account deficit and vice versa. Together, these accounts constitute Balance of Payment (BOP), because of their offsetting nature the complete understanding of these two accounts is crucial for traders.

How does the Reserve Bank of Australia, Institute monetary policy?

Reserve Bank of Australia (RBA) was constituted under the Reserve Bank Act 1959, and is responsible for preparation and carrying out of monetary policy.
By definition monetary policy has been a process by which the monetary authority holds the provision of money, often targeting interest rates to achieve economic targets of low inflation and long term growth stability.
Objectives of Monetary policy
In setting monetary policy RBA is responsible to maintain the pursuit:

Stability of Australian currency
Full Employment
Economic Prosperity and welfare of the people of Australia.

In order to achieve above mentioned objectives, the Reserve Bank of Australia sets a targeted official cash rate (interbank overnight rate). The cash rate adjustments influence the other interest rate in the economy, expectations of community, exchange rate and ultimately involve the pace of rising prices (inflation rate).
The appropriate target inflation rate agreed by RBA and Govt is at 2 to 3 percent on average over the cycle, as this rate will not materially affect the spending and investment patterns in the economy.
As monetary policy is a means of influencing the economy by controlling the supply of money. By Act of Parliament RBA can manage the quantity of circulation of money through changing cash rate, buying and selling Govt securities and by making changes to statutory reserve deposits.
The RBA usually meets once in every month, examine the health of the economic system as a whole and by reviewing the checklist of different economic indicators both domestic and international to decide on their monetary policy. Any decision/changes needed at the conclusion of the meeting, then communicated publicly.
There are two types of monetary policies which are as follows:
Expansionary monetary policy:
It stimulates production and employment through an increase in the supply of money on credit in the market. The RBA can implement this policy by decreasing the cash rate or lowering reserve requirements in order to promote borrowing and spending in the economy. Small businesses often benefit with the execution of the expansionary monetary policy, but it has some drawbacks like decrease in value of currency, raise in inflation, output shortage, higher demands of wage etc.
The objective of the RBA is to balance the available money to interest rate in order to ensure expansionary effect on the economic system.
Contractionary Monetary policy:
The primary aim of this type of policy is to draw out money out of the economic system to prevent the rising prices, decrease consumer spending and increase the value of currency. The activities through which RBA tightens monetary policy includes decreasing the official cash rate or by increasing the reserve requirements from other banks make it harder for consumers and investors to borrow money and persuade them not to drop more money. A monetary contraction further stabilize the prices of goods as inflation goes down.
This policy slows down production because there is reduce demand for their products. An investor can also plan to cease planned expansion and this may cause unemployment in the future.

What are the implications of rising or high inflation?

In simple language inflation means an overall increase in prices of goods and services in the economy or decrease in the purchasing power of money over time. Inflation is caused by an increase in demand for commodities and services strongly outweighs the supply of commodities and services in the economy. Inflation rate can easily be calculated on monthly or yearly basis by applying the CPI.
Inflation rate in Australia as reported by the Australian Bureau of Statistic is 2.9% in the first three months of 2014, up from 2.7 percent in the previous quarter but still it is below market forecasts. This cost increase was primarily due to seasonal increases in the cost of health care, school fees, transport and by large increases in tobacco duties.
Impact of High Inflation on the Economy:
High inflation is harmful to the economy as it moves in many ways such as:

Distort Consumer Behavior:

Consumer purchases their future required goods in advance because of the fear of price increase this can create a sudden shortage of goods in the market.

Higher Wage Demands:

Prices increase lead to higher wage demand as the fixed income earners require more money to keep their previous living standard. This process is called wage-price spiral.

Greater Uncertainity:

During inflation, rapid fluctuation in inflation rate can undermine business confidence. As it makes difficult for business organizations to accurately determine prices for their products and their returns from investment i.e. budgeting and investment valuation become difficult Firms may postpone their investment expansion because of lower consumer spending and this will adversely affect the economic growth in the economy.

Savings Decrease:

At high inflation times, people spend more money to keep their previous living standard therefore least amount they keep. As savings in the economy decrease less loanable funds are available for the firms to invest.

Unemployment Rise:

When the firms decide to curtail their current production or lay off their planned expansions they will not hire more workers this leads to lower job opportunities available in the economy.

Damage to Export Competitiveness:

Due to high inflation, the production cost of goods rise and their export will become less competitive in the international marketplace. This has an adverse result on the Balance of payments.

Social Unrest:

High inflation lead to a general feeling of discomfort for households as their purchasing power is falling and they have to postpone many of their desires.

Hoarding in Economy Increase:

Rapid increase in prices can sometime result in hoarding of basic commodities to gain more profit margins.

What is the main economic indicator of growth in the economy?

Economic indicator shows in which the direction of the economy is going. There are three primary types of economic Indicators i.e Leading, Coincident and Lagging indicators. In monitoring the economic growth and health, Govt, reserve bank (RBA) and other economist not only observe one indicator, simply stick with a large no domestic and of key economic indicators like inflation, GDP, inflation, Employment, wages, consumer an international d investment spending, interest rate, Balance of payment, Exchange rate etc. But the most comprehensive measure of economic performance is GDP (Gross Domestic Product). It is the best measure as it includes the output of all sectors and gives overall performance of the economy. It is likewise applied to evaluate the quality and success of Govt policy to attempt to attain the target economic growth.
GDP by definition is the total value of all final goods and services produced in a country within a year. There are two methods normally applied to calculate GDP:

Expenditure Approach
Income Approach

Expenditure Approach:-

The total amounts spent on the goods a and services produced in a nation by households, firms, Govt and foreigners. Households consumptions (C) include all spending for the consumption of goods and services, business firms also consumes product in the form of investment (I) in capital goods. Capital goods means the tools and technology firms purchase to use in the production. Govt also consume products in the form of infrastructure goods (roads, bridges), services like education (public schools), health care (old age/poor persons medical coverage). Foreigners when purchase our nation’s goods (X) it increase GDP in the form of and when our other nation purchase other countries (M) products it decreases nations GDP.
The formula to calculate GDP by expenditure Approach:-
GDP = C + I + G + ( X – M )

Income Approach

In an economy in different ways, such as rentals (Land), Wages depending on skilled /unskilled Capital income (Interest income from their savings at banks or other savings institutions) and in of profits from managing their own businesses (Enterpreurship). If we add all these types of incomes, we get the total of the nation’s income. The formula to calculate GDP by income approach is given below.
GDP = Rentals (R) + Wages (W) + Interest (I) + Profits (P)
For the economy as a whole total Income is equal to total expenditure because every dollar spend by a buyer is a dollar income for a seller.
The limitations of using GDP as economic indicator:-

GDP does not count for volunteer work which people do freely. People work freely in schools, hospitals etc..
GDP didn’t include the effect of rebuilding after a natural disaster or war. Rebuilding increase the GDP.
GDP does not consider the quality of goods. The consumer may go for cheap/low quality goods instead of expensive one this may lead to repetitive buying as of low quality aspect. More buying pattern affects the affect the GDP.

Nevertheless despite of its few limitations economist uses GDP as to assess whether the purchasing ability of the nation increase / decline in the economy and also to quantify the relative growth, wealth and prosperity of different countries.