When inflation rate is above RBA’s target, it will cause concern for both the economy and society. The concerns/effects of inflation can be broadly categorized into three areas; they are output effects, income redistribution and wealth effects and effects on international competitiveness.
The presence of inflation can have impact on output level is explained by the uncertainty. Continual price raises lead to uncertainty about future and thus make decision-making more difficult for investors because investments seem more risky during high inflation, thus investors may stop investing during inflation for guaranteeing their rate of returns.
In addition, the production costs pushed to increase associated with all prices to increase during inflation. Thus, the final output generated will be decreased with the same amount of input.
Consequently, the output must be decreased from the decrease in real output and decrease in investment.
- Income redistribution and wealth effects
The burden of inflation does not fall evenly on all sectors if the community. Some households are worse off. Others, particularly those who are able to anticipate the inflation, may be able to arrange their financial affairs to benefit from expected price increases. The following comparisons give the explanation of how someone worse off when someone else better off.
- Borrowers VS lenders
Borrowers tend to benefit from inflation, because they are able to build up their assets on borrowed money, knowing that the real value of their repayments will fall over time. In other words, borrowers’ purchasing power will increase during inflation.
However, lenders must be worse off when borrowers better off during inflation. This means, long term lenders will be repaid in inflated dollars which have reduced lenders’ purchasing power.
- Tax payers VS government
Taxpayers suffer from “bracket creep” as inflation gradually causes their income levels to rise to levels where they are liable for higher marginal rates of taxations. However, government revenue increases as a result of this “bracket creep” (Parry,G & Kemp, S 2005).
- Effects on international competitiveness.
A country will be at a disadvantage when its inflation rate is higher than its competitors, because when price rises, demand for exports falls but demand for imports tend to increase. Thus, Australian currency tends to depreciate (because less demand for Australian’s goods) (Stegman,T & Junor, B 1991). Therefore, international competitiveness of Australia will be negatively influenced when inflation above RBA’s target.
-RBA’s actions to eliminate expansionary gap
Expansionary gap occurs when actual output higher than potential output (Bernanke,B.S & Olekalns, N& Frank,R.H 2008). As shown in the graph below, expansionary gap is the difference between Y and Y*.
Figure2 (Day,G 2009 P6)
The RBA can use contractionary monetary policy to reduce aggregate expenditure/aggregate demand by adopting the combination of open market operation and transmission mechanism to increase interest rates.
The RBA uses open market operation in the overnight cash market to change the cash rate. This market balances the demand for and supply of overnight funds between financial institutions and the Reserve Bank. An open market operation is the buying and selling of Australian government securities. When the inflation rate is above the RBA’s target, RBA will aim to tighten monetary policy (Parry,G & Kemp, S 2005).
.This means, Reserve Bank will enter the money market to create a shortage of cash by selling securities. This will increase the cash rate-prices of cash-and will cause other short and long run interest rates to rise.
The key objective of monetary policy is price stability (Parry,G & Kemp, S 2005). Higher interest rate will discourage the borrowing and help to restrain private spending (includes both the consumption and investment). Therefore, a rise in interest rates is having contractionary effects on aggregate demand, so that the higher inflation can be controlled to decrease.
Since RBA’s domestic market operation has formed the basis on which monetary policy works, the focus now is to look at how the changes in interest rate affect the level of economic activities in Australian economy. This process is called “Transmission Mechanism” (Parry,G & Kemp, S 2005).
.
Changes in interest rates affect:
- Saving and investment decisions-a rise in interest rate will increase households’ incentives to save because it will increase the return on deposits. Meanwhile, the rise in interest rate increases the costs of borrowing and thus reduces the investment.
- Cash flow of households and firms- a rise in mortgage rates reduces the amount for households to spend on goods and services. If interest rates rise, firms will have less cash to pay expenses and thus unlikely to expand production or increase employment. As a result, the demand will eventually fall when the firms’ supply falls (Parry,G & Kemp, S 2005).
To conclude the points above, when the consumption and investment have been well-controlled and tend to decrease under the use of contractionary monetary policy, the aggregate expenditure will decrease, so that the inflation pressure for Australian economy will slow down.
Conclusion
To sum up, if Australian inflation rate above the RBA’s target, it would cause concerns for both the economy and society. These concerns categorized into the output effects, income redistribution and wealth effect and the effects on a country’s international competitiveness. In order to eliminate the expansionary gap associated with the inflation, RBA can use the contractionary monetary policy to increase the interest rates, which can be done by combining the open market operation and transmission mechanism. Consequently, the inflation can be effectively controlled accompany with the increase in interest rates.
Bibliography
Bernanke,B.S, Olekalns, N and Frank,R.H (2008) Principles of macroeconomics McGraw Hill Australia Pty Limited
Figure 1- Bernanke,B.S, Olekalns, N and Frank,R.H (2008) P315 Principles of macroeconomics McGraw Hill Australia Pty Limited
Figure 2- lecture notes Day,G. 2009. Money Prices and the Reserve Bank (p6). Lecture notes distributed in the unit Introductory Macroeconomics (ECON1002) at the University of Sydney, Comperdown on 2nd September 2009.
Lecture notes Day,G. 2009. Money Prices and the Reserve Bank (p40). Lecture notes distributed in the unit Introductory Macroeconomics (ECON1002) at the University of Sydney, Comperdown on 2nd September 2009.
Parry,G and. Kemp, S (2005) Exploring Macroeconomics WA Print
Stegman,T and Junor, B (1991) Introductory Macroeconomics Harcourt Brace & Company, Australia
