Inflation

What is inflation?

• A sustained increase in the general level of prices in an economy.

• Maintaining low inflation is a major objective of economic policy because of the benefits that lower inflation provides to the economy in the long run.

How is it measured?

• Inflation rate (%) =

• CPIcy - CPIpy x 100• CPIpy 1

• Where CPI = Consumer Price Index

• cy = current year

• py = previous year

How is CPI measured?

• The Consumer Price Index is calculated by summarising the movement in the prices of selected goods and services, weighted according to their significance for the average Australian household. These include:

Food Housing Transport

Alcohol and tobacco

Clothing and footwear

Communication

Recreation Furnishing, supplies, services

Health

Main causes of inflation

• Demand-pull inflation (AD > Y)• Cost-push inflation (costs of production

increase)• Inflationary expectations• Imported inflation (increase in cost of imported

goods or depreciation of $Aus)• Government policies (e.g. GST)• Excessive increases in the money supply (where

increase in money supply > growth rate of the economy)

Effects of inflation

• Economic growth and uncertainty – savings and investment may suffer

• Wages – wage-price inflationary spiral• Income distribution – impact of inflation on fixed

incomes and savings• Unemployment• International competitiveness – international

investors are reluctant to invest $ in a high inflation economy

• Exchange rate impacts• Interest rates

Sustaining low inflation

• Monetary policy is the major tool used to reduce inflation.

• If inflation starts rising, the Reserve Bank is able to increase interest rates throughout the economy by tightening monetary policy.

• Pre-emptive monetary policy by the RBA in recent years has had the effect of lowering inflationary expectations.

Microeconomic reform policies• Microeconomic policies are aimed at

certain sectors of industry.• Reduced protection has lowered the price

of imports. This makes it more difficult for domestic producers to raise their prices.

• Deregulation of the labour market has reduced the problem of cost-push inflation. Wages increases are linked to productivity improvements – the economy will be able to afford real wage increases without inflationary pressures.