Inflation Research Paper

The Nature and Extent of Inflation
Inflation is a sustained rise in the general level of prices in an economy. Several measurements of inflation are available but the most widely used measurement in Australia is the Consumer Price Index (CPI), which measures the percentage change in the prices of selected consumer goods and services over time and therefore reflects changes in the cost of living.

The rate of change in the CPI is known as the headline rate of inflation since it covers the movement in the prices of a basket of goods and services weighted according to their significance in the average Australian household.

Some problems in the interpretation of the CPI include the volatility of some prices due to seasonal conditions (such as food prices), and the change in the weightings given to various categories of spending over time due to changes in consumer spending behaviour.

The CPI for the March quarter 2003 showed a rise in the general level of prices of 1.3%, bringing the annual rate of inflation to 3.4%. Hence, the inflation rate has moved outside the RBA target range of 2% – 3%.

Additional measures of inflation are also used to assess the degree of price pressures in the economy. One such measure is the underlying rate of inflation, which is a calculation of inflation that removes one off seasonal factors such as higher food prices due to drought or government induced interest rate rises. It is a better indicator of trend inflation in the economy than headline inflation and is calculated by Treasury and used in economic forecasting. The Treasury forecasted inflation rate for 2003-04 is 2.75%.

The Australian Bureau of Statistics has also recently developed new measurements of inflation. The Price Index of Domestic Final Purchases analyses price changes on the demand side of the economy, which the Stage of Production Index analyses price changes on the supply side.

The Causes of Inflation
Demand-pull Inflation
When the level of aggregate demand exceeds the productive capacity of the economy, demand-pull inflation occurs, as output cannot expand any further. Consumers force prices up by bidding against each other for the limited goods and services available.

Demand-pull inflation can be caused by increases in consumption, investment, money supply, government expenditure and export income.

Cost-push Inflation
Cost-push inflation results from a decrease in aggregate supply caused by an increase in the costs of production. When there is an increase in costs of production, such as an increase in the price of raw materials, business attempt to pass them on to the consumer by raising the prices of their products.
One of the main causes of cost-push inflation is an increase in wages, as wages costs account for up to 70% of total business costs. When wages increase faster than productivity, the cost of labour for each unit of output increases. Businesses will attempt to pass the wage increase on to consumers in order to maintain profitability.

Imported Inflation
This type of inflation is transferred to Australia through international transactions. The most obvious cause of inflation is a rise in import prices. If there is an increase in the price of imported goods, importers will attempt to pass on the effect of higher costs onto consumers in the form of higher prices, leading to imported inflation. A depreciation in the $A will also increase the domestic price of imports and will lead to inflation.

Inflationary Expectations
If the key participants in the economy expect an increase in the rate of inflation, they will attempt to protect themselves from it. In doing so, they will in fact bring about the expected rise in inflation. For example, if employers expected further increases in their costs of production, they may raise prices in order to cover the expected increase in costs, resulting in inflation. Similarly, if trade unions argue for wage increases based on anticipated inflation rather than on the current inflation rate, it will lead to cost-push inflation.

The Effects of Inflation
1. Heightens inflationary expectations, leading to a cost-push cycle.
2. Consumers lose purchasing power due to a decrease in real incomes, leading to a decrease in living standards.
3. Workers suffer a fall in real wages and those on low wages or fixed incomes also experience a fall. There is therefore a redistribution of income away from wage and salary earners to those receiving profit and dividend income.
4. Producers may react to higher costs by putting up prices and may shed workers to contain their costs, leading to stagflation.
5. Exporters may find it difficult to compete with higher production costs, leading to a temporary loss in competitiveness.
6. Savers will find that the real value of savings well decline unless interest rates are raised. Whilst this may increase real returns, it will cripple domestic investment.
7. Investors will reduce their demand for funds due to less profitability. Some investment may increase, but it will be in speculation, eg property, rather than investment in productive capacity.
8. Inflation will force up nominal wages for workers, pushing them into higher tax brackets and therefore generating greater government revenue (Fiscal drag). This puts a brake on the economy.

Government Responses to Inflation
An important source of actual inflation is expectations of inflation. To break the cycle of inflationary expectations, the RBA together with the government adopted the model of inflation targeting in the 1990s. Inflation targeting refers to the setting of an explicit range for the rate of inflation and making known what this target is. The RBA is then given the objective of using its policies to keep the inflation rate between 2% – 3%.

By showing a commitment to low inflation, the government has been able to lower inflationary expectations.

The deregulation of the labour market has reduced the problem of cost-push inflation. By the move to a decentralized method of wage determination, increases in wages are now associated more closely with increases in productivity. The economy can therefore afford real wage increases without inflationary pressures.

In a period of high inflation, the Reserve Bank will raise interest rates throughout the economy by tightening monetary policy. This leads to reduced consumer and investment spending, slowing the rate of demand growth in the economy and thereby lowering inflation.
The RBA has also used pre-emptive monetary policy to take action against inflation before it becomes a problem. An example of this occurred in mid 2002.

Another important factor contributing to low inflation is microeconomic reform. Reduced protection has made imports increase in competitiveness, making them cheaper. This then makes it more difficult for domestic producers to raise their prices. Some industries in Australia, which have generally been considered as monopolies, have also been opened to competition. An obvious example is the telecommunications industry where the cost of local calls has now fallen to as low as 15 cents with some carriers.

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