Infation HSC Notes

Recent Trends in Inflation

The most significant microeconomic achievement in the Australian economy of recent times is the sustained inflation rate. After two decades of high inflation levels, the Australian economy lowered its inflation rate and kept it down, and was able to sustain the lowest rate since the 1960s. In 2993 the RBA started to target an inflation rate of 2-3%, this target was formalised in 2996. Generally the inflation rate has stayed in this target range. It did go above the range in 2000 due to introduction of the GST which caused a one off increase in the headline inflation. Between 1996 and 2009 both the headline and underlying inflation rate has averaged 2.6%.

The high inflation rate of the 1970s and the 1980s was only stopped by the recession of the early 1990s. Australia emerged from this recession with historically low inflation rates, and soon after the RBA started to target monetary policy to sustain 2-3% inflation. Whenever there have been inflationary pressures the RBA has been able to tighten interest to slow down the growth in demand and restrain any inflationary pressures. Other global factors that contributed to this low inflation level, was increased completion, lower global inflation.

Despite the economic growth of the 1990s and the 2000s the inflation pressured were constrained as monetary policy was effective. Some economists suggest that the sustained rate of inflation was due to the structural changes during the 1980s and 1990s. Microeconomic reform increased the intensity of domestic and foreign completion. Also the productivity growth in the 1990s contributed to restrained inflation. Hence these factors made it possible for Australia to experience strong economic growth, falling cyclical unemployment and low inflation.

Between 2005 and 2008, the inflationary pressures were the strongest, as underlying inflation peaked at 4.7% due to both the higher global prices (for food, energy etc.) and the strength of economic activity, as the Australia economy was close to full capacity, productivity costs (labour,  materials and transport) were rising and these all contributed to higher consumer prices.

The onset of the global financial recession in 2008 reduced the inflationary pressures. The slower economic growth and incomes growth reduced the ability of businesses to increase consumer prices, while lower demand for labour and materials reduced pressures on business costs. By the 2009, the underlying and headline inflation are returned back into the RBA’s target range.

Causes of Inflation

Demand-Pull Inflation

• When aggregate demand exceeds the productive capacity  of the economy, prices rise as output cannot expand any further in the short term
• Consumers force prices up by bidding against each other for the limited amount of goods and services
• Hence consumers are willing to pay a higher price for any given level of supply
• Hence the prices will therefore increase, causing an expansion in supply.

Cost-Pull Inflation

• This is caused by a general increase in the costs of the factors of production.
• When the production costs rise, firs pass on their additional costs directly to the customers through an increase in prices of their goods and services
• The major source of this form of inflation in Australia is oil price and wages.
• When wages outstrip increased in productivity, the cost of labour per unit of output rises. Firms pass these costs onto to buyers (wages represent 60% of their costs).
• Similarly, an increase in the price of oil or other raw material will generally feed directly an increase in the prices of goods by firms to maintain their profits.

Inflationary Expectations

• If individuals in an economy except higher inflation in the future, they will act in a way to increase the inflation. This can be done I two ways:

• Prices of g’s/s’s expected to increase → consumers purchase goods before price increases. The Increase in consumption → higher demand-pull inflation. Also if firms expect that demand for their product will increase → raise prices to maximise π →increase in
• Employees expect inflation to increase → during wage negations they will tend to ask for a higher wage rise to keep their purchasing power of their wage. Higher wages increases → increase in cost pull inflation

• Inflationary expectation area problem to policy makers. Individuals expect higher inflation → bring act to bring higher inflation. High inflationary expectation → higher inflation → economic contraction.

Imported Inflation

• Major cause of this is raising import prices. This will increase the price of imported goods hence increasing the inflation rate.
• A depreciation of the Australia dollar will also increase the domestic price of imports ➔↑
• If imports face competition from locally made products → importers reduce π margins → not pass on to consumers the full effect of depreciation or overseas price rise

Other Causes

• Government polices → increased indirect taxes. E.g. the introduction of the GST in 2000 temporarily increased the. Other measured of government’s → deregulation of an industry. Changing tariff rates, imposing  price controls or price monitoring and increasing charges for goods and services
• When money supply outstrips growth rate → increased volume of money chasing same amount of goods and services → prices likely to increase→ hence increase the inflation rate.

Effects of Inflation

Economic Growth and Uncertainty

• Inflation main constrain on econ. growth. Excessive econ. growth → raise inflationary pressures, through increase wage demands and strong consumer demand bidding.
• Sustained lower inflation rate allows moderate econ. growth to be maintained → without need for an increase in I.R.
• A sustained inflation rate → long period (18 years) of economic growth
• Higher inflation distorts economic decisions → producers and consumers change spending and investment decisions to minimise effects of inflation, e.g. buying assets instead of investment. Investment is discourages as businesses are uncertain about future price and costs hence π levels.
• Low inflation removes distortion to investment and savings decisions. Low inflation resorts incentive to invest in long term productive assets rather than short term speculative investments.
• Higher inflation → distorts consumers’ decisions to spend/save disposable income. Consumers more likely to spend and do not spend during times of high inflation; purchasing power is reduced over timed. While low inflation encourages saving. Australia has not been consistent with this principle.

Wages

• High inflation → increase nominal age demands, employees seek larger wage increases to conserve their purchasing power.
• This can lead to a WAGE-PRICE INFLATIONARY SPIRAL, where wage increases lead to higher prices and so on, which will lead to higher demands.

Income Distribution

• High inflation rates → negative impact on distribution of income. Low income earners find that their incomes do not rise as quickly as prices. Lower income earners face higher interest rates on their borrowing
• High rates of inflation → effect those who are on fixed incomes and those are not indexed to the rate of inflation
• Higher inflation can also erode savings → those who cannot protect their savings will see them decline.

Unemployment

• Level of inflation and unemployment closely linked. [SEE UNEMPLOYMENT NOTES].
• Higher inflation → contractionary fiscal and monetary policies → slower econ. growth → higher unemployment in short/medium term.
•  High levels of unemployment = low inflation rates, while low levels of unemployment = higher inflation
• In long term this inverse relationship doesn’t always hold. E.g. 1970s Australia experienced simultaneous increases in inflation and unemployment [STAGFLATION]. While in the 1990s/2000s Australia experienced low inflation and falling unemployment.

International Competitiveness

• High inflation → increases prices of Australia’s exports → reducing international competitiveness → hence export quantity reduced → ∴ ↓ export revenue.
• Price of domestic goods ↑, consumers switch to import substitutes → worsening trade deficit.
• Low inflation → improve trade deficit → more attractive to other countries to purchase Australian g’s/s’s → + local goods more competitive with import -. Expansion of exports

Exchange Rate Impacts

• Short term: higher inflation → appreciation of XΔ rate→speculators expect RBA to raise I.R. to attract greater financial flows.
• High inflation → cause currency to depreciate over times.
• Australian experience offers some evidence between XΔ and inflation rate.
• Longer term: sustained low inflation → greater international confidence in Australian economy → strengthening value of dollar

Interest Rate        

• Lower inflation → reductions in nominal interest rates. Nominal I.R. based on real rate of return + inflation.
• Reduction in inflation rate since early 1990s → lower nominal interest rates.
• Higher inflation → higher interest rates as RBA tries to reduce demand pressures in the economy and avoid negative effects.

Other Effects

• Inefficient allocation of resources: Higher inflation → speculation rather than investment. Investors more interest in capital gain than productive investment.
• Balance of Payments: Rising rate of inflation will affect Australia’s international export competitiveness. If Inflation rate exceeds that of our major trading partners then export competitiveness will erode. Reduced export competiveness will lead to lower export revenue and a lower merchandise trade balance.

Policies to Control Inflation

Monetary Policy

• Played a major role in sustaining inflation rate since the 1990s
• Short/medium term: major toll used to reduce inflation and attempts to sustain inflation without creating excessive pressures.
• RBA curbs inflationary pressures, by increasing interest rates → tightening monetary policy
• This dampens consumer and investment spending → lower level of economic activity and therefore lower inflation
• Pre-Emptive monetary policy: taking action before inflationary pressures arise. E.g. RBA increased interest rates 8 times between 2006 and mid 2008 in response to the continued economic growth  → recue demand-pull inflation. RBA aims to increase I.R. before inflation reaches top of target band.
• The use of monetary policy by the RBA has also meant that inflationary expectations have been lowered and thus further reducing the inflation rate.

Fiscal Policy

• Fiscal policy plays a more supporting role to manage the inflation rate. By increasing revenue and decreasing spending the government can in effect reduce demand pressures in the economy → reducing demand-pull inflation.
• E.g. 2008-09 budget government increased the size of its forecast budget surplus → minimising inflationary pressures by reducing public demand,
• Fiscal policy aimed to reduce the inflation rate may also reduce the need for higher interest rates.

Microeconomic Reform Policies

• Reduced protection has lowered the prices of imports. Also it has increased the competition faced by dom. producers from both foreign completion and new entrants to domestic markets → more difficult for domestic producers to increase prices
• Reforms to labour market → ensure that wages increases are only linked to productivity improvement. If productivity rises → economy able to afford REAL wage increases without any inflationary pressures.
• Deregulated labour market → strong demand for skilled workers → higher wages in industries experiencing a shortage of skilled workers.
• Government: greater spending on economic infrastructure (roads, railways and port) necessary to reduce capacity constraints faced by businesses which would increase production costs and contribute to inflation.