Discussion of the Cause and Effect of Inflation

Discussion of the causes and effects of inflation, outlining how it is measure, and policies to maintain sustainable inflation rates.

Inflation refers to a sustained increase in the general level of prices in an economy. Inflation is an economic problem that has negative impacts on the level of economic growth as well as international competitiveness and income inequality. Maintaining a low inflation rate is a major economic objective because of the advantages of lower inflation for the economy in the long term. Australia has experience relatively low levels of inflation since the early 1990’s as global inflation rates have been low, and foreign economic policy has placed a great emphasis on maintaining a low level of inflation.

Measuring the Inflation rate

The most-widely used measure of inflation in Australia is the percentage change in the Consumer Price Index (CPI). The CPI refers to a summary of the movement in the prices of a basket of goods and services, weighted against their significance in an Australian household. The annual rate of inflation is calculated by the percentage change in the CPI over that year;

Inflation rate (%) = CPICY - CPIPY / CPIPY x 100/1

The basket of goods and services covers a wide selection which reflects the average household spending patterns. The percentage change in CPI also acts as a reflection of general changes in the cost of living. The CPI is complied and calculated by the Australian Bureau of Statistics, and is published every three months.

Although the basket of goods in the CPI is broad, it does exclude some items of household spending. These include; changes in mortgage interest rates as well as consumer credit charges. Housing, food, and recreation are among the top expenditure groups which are calculated in the CPI basket. The CPI also does not include property prices, therefore recent changes in residential property prices have not been reflected by the CPI calculations.
However, the CPI is not always accurate in calculating the official rate of inflation, as it includes some goods and services whose prices are subject to high levels of volatility. For this reason, economists prefer to use the underlying level of inflation. Underlying inflation removes the effects of price volatility in expenditure groups of the goods and services basket.

There is no single measure of underlying inflation in Australia, as both Treasury and the RBA have their own methods of calculation. Generally, economists focus on the two measures of underlying inflation published by the RBA which include; the trimmed mean and the weighted median.
Trimmed mean; inflation is determined by calculating the average inflation rate after excluding the 15 per cent of items with the largest price increases and the 15 per cent of items with the smallest prices increases/largest price falls
Weighted median; inflation is calculated by comparing the inflation rate of every item in the CPI and identifying the middle observation.
The estimate for the underlying inflation rate by the RBA is determined by finding the average of the two measures. Underlying inflation levels had suggest Australia’s price pressures were slowly building until the onset of the global financial crisis.

The causes of inflation

Economists generally refer to four main causes of inflation; demand-pull, cost-push, inflationary expectations and imported inflation.
Demand-pull inflation: If aggregate demand exceeds the productive capacity in a market economy, prices rise as output cannot expand any further in the short term. Consumers will force prices up by bidding against one another for the limited supply of goods and services available in the economy.

Cost-push inflation: This is caused by an increase in the level of costs of production. As production costs rise, firms attempt to pass the rise onto consumers through and increase in price levels. Major sources of cost-push inflation in Australia include oil prices and wages. Since wages often account for a major cost in business expenditure, firms will attempt to pass on a wage increase to consumers so as to maintain profitability.

Inflationary expectations: If consumers expect a future rise in the level of inflation, the may react in a way which will increase the level of inflation. The two main ways inflationary expectations will bring about higher inflation include;

If prices are expected to rise, consumers will purchase before the increase in prices. This will cause an increase in consumption resulting in higher demand-pull inflation. If a firm forecasts an increase in demand for their product, they may increase the price of the product leading to an increase in inflation.
If employees expect wages to rise, they will take this into account when negotiating wage increases. Higher wage increases may be passed on by firms leading to higher cost-push inflation.

Imported inflation; This brand of inflation is transferred to Australia by way of international transactions, most obviously through a rise in the level of import prices. A depreciation of the Australian Dollar will lead to an increase in the domestic price of imports thereby increasing the level of inflation.

Other Causes; two other possible causes leading to a rise in the level of inflation include:
1. Government policies; may either directly influence inflation through or indirectly influence inflation through taxes.
2. Excessive increases in the money supply; if money supply outstrips the level of economic growth, an increased volume of money will be left chasing the same amount of goods and services thereby increasing the level of inflation.

The effects of inflation

Inflation has significant impacts on the economy in both the short term and the long term. Generally the higher the rate of inflation, the more severe the effects are on the economy. The impacts of inflation include:

Economic growth and uncertainty - Inflation is regarded as the main constraint on economic growth. Rising inflation results ion increased wage demands and consumers bidding up price levels. Prolonged low inflation rates allows for a moderate rate of economic growth, thereby avoiding limiting the risk of higher interest rates. High inflation distorts economic decision making, low inflation has a positive impact on the economy, thereby it removes the distortion on decision making that high inflation brings.

Wages - The level of inflation is a major influence on nominal wage demands. Higer rates of inflation can lead to a wage-price inflationary spiral, where wage increases lead to higher prices, thereby leading to higher wage demands and so on.

Income Distribution - High inflation rates tend to have a negative impact on the distribution of income as lower-income earners find that their incomes do not rise at the same rate as prices. Generally a high level of inflation will hurt those individuals who are on fixed incomes or whose incomes are not indexed to the rate of inflation.

Unemployment - The levels of inflation and unemployment are closely correlated in the short term. High inflation will generally result in Contractionary fiscal and monetary policy in the short to medium term, thereby reducing the level of economic growth and increasing the rate of unemployment.
International competitiveness; high rates of inflation results in increased prices for exports, thereby reducing the competitiveness and quantity of exports. Consumers will likely then switch to import substitutes, thereby worsening the Current Account Deficit.
Exchange rate impacts; Higher inflation in the short term may lead to an appreciation of the Australian Dollar, as speculators expect the RBA to raise interest rates in response, thereby attracting increased financial flows. However high levels of inflation in the long-term will often result in a sustained depreciation of the Australian dollar.

Interest rates - Lower inflation usually brings about reductions in the level of nominal interest rates, as nominal interest rates are based on a real rate of return plus inflation.

Policies to sustain low inflation

Monetary policy has been the main tool used by the RBA in maintiaining a low level of inflation, occasionally other parts of the policy mix are employed to address price pressures in the economy.

Monetary policy has been used to sustain growth at a lvele that does not create excessive inflationary pressures. If inflation begins to rise, the RBA will tighten monetary policy, thereby dampening consumer and investment spending – resulting in a lower level of economic growth and consequently a lower level of inflation.

The RBA often employs pre-emptive monetary policy, taking action against inflation before it emegeres as a problem. The RBA tightened monetary policy eight times between 2005 and mid-2008, in response to increased economic growth and a concern about demand-pull inflationary pressures.

Fiscal policy has also played a role in maintain low inflation levels. If the government uses Contractionary fiscal policy, where it would increase revenue through taxation and decrease spending; the level of demand-pull inflation will decrease. Fiscal policy measures that support low inflation levels may reduce the need for higher interest rates to combat an inflation problem.

The government has also implemented microeconomic reform policies in reducing the level of inflation. A reduced level of protection has lowered the prices of imports. This has resulted in an increase in foreign competition, thereby making it difficult for domestic producers to increase their price levels. Reforms in the labour market have been implemented to ensure that increases in wage levels correlate with an increase in the level of productivity. Governments have argued in recent years that spending on infrastructure has helped reduce the capacity constraints faced by business that increase production costs and contribute to inflation.

Conclusion

Inflation is a significant economic problem, facing all economies around the world. The impacts of a high level of inflation are negative and often contribute to an increase in the level of income inequality as well as a range of other areas throughout the economy. For this reason, governments in close connection with the central banking institutions of an economy work together to maintain a low level of inflation so as to avoid the various consequences associated with a high level of inflation.