Analyse the causes and effects of recent changes in Australias inflation rate Inflation is the sustained increase in the

general level of prices in an economy. It is usually measured by changes in the Consumer Price Index (CPI) which is a measure of the movement of prices of a basket of goods and services and is weighted to the significance to the average Australian household. After being in excess of 10% in the 1980s, inflation has fallen to much lower levels in recent years, primarily due to the effectiveness of actions by the Reserve Bank of Australia (RBA). Inflation can be caused by a number of economic factors and has significant negative impacts on individuals, firms and governments. However, there are also possible advantages of inflation in some cases. The fall in inflation in the early 1990s can be largely attributed to the effectiveness of monetary police initiated by the RBA. In tightening monetary policy by increasing interest rates, the RBA was able to limit the level of aggregate demand and therefore help lower demand inflation. The RBA also introduced a 2-3% inflation rate target. The recession of 1991-92 also helped to lower inflationary pressures. Other factors that have contributed to relatively low inflation figures include the appreciation of the Australian dollar which has led to lower imported inflation and lead to higher productivity which has helped to ease supply constraints and avoid high demand inflation. It should be noted, however, that productivity is now falling in Australia leading to potential increases in cost inflation. However, recent CPI data released by the Australian Bureau of Statistics show how the first two quarters of 2011 reflect the re-emergence of inflationary pressures in Australia. The data showed that the current annual inflation rate was 3.6%; outside of the RBAs target inflation rate band. This recent increase in inflation has been caused by a number of factors. Firstly, rising petrol prices has significantly impacted on cost inflation as many firms use petrol is their production. These additional costs have then been passed on through higher prices particularly in the transport sector. The sharp increase in banana prices by 138% as a result of limited supply following the Queensland floods has also contributed greatly to the increased CPI. Australias poor labour productivity performance and wages growth in 2011 has created increased cost inflation as wages have grown faster than productivity meaning each unit of labour now costs more. Wages have grown due to the high levels of bargaining power generated by the low levels of unemployment and an economy operating close to full capacity. These supply constraints have also impacted on demand inflation as any increases in aggregate demand will force up prices rather than increasing output. The government has introduced various measures in the 2011 federal budget in order to overcome these supply constraints and help avoid high levels of inflation. Recent increases in inflation can also be attributed to soaring investment as a result of the mining boom which has created

wage and price pressures as the value of the level of national investment reached $830billion for the second quarter of 2011. Finally, imported inflation has also contributed to the 3.7% inflation as building wage pressures and high inflation in countries such as China have increased the price average price of imports despite the strong Australian dollar. There are a number of negative consequences associated with the re-emergence of inflationary pressures in Australia. Individuals are perhaps the most highly impacted group by inflation. When the rate of inflation is higher than the annual increase in nominal wages, then workers end up receiving lower real wages i.e. their wages now have less purchasing power. Often workers on low wages are disadvantaged as they often have low bargaining power and cannot receive increases in their nominal wage to match inflation. This also creates inequality between high and low income earners as profits and dividends tend to keep their real value. Inflation also impacts on individuals who have savings as the real value of their savings will fall if the rate of inflation is higher than the rate of interest being earned on the savings. For example, savings of $100,000 will only having the purchasing power of $90,000 in the following year if inflation is at 10%. So if the individual is not earning in excess of 10% interest, their savings will decline in real value. Firms are also negatively impacted by inflation as workers will often aim to increase their wages in order to ensure they maintain their real value. This may lead to lower profits and lower international competitiveness of exporting firms. Inflation also affects governments and policy decisions. Often contractionary fiscal policy is necessary to lower inflation by decreasing aggregate demand. However, this will limit the economic growth of the economy and is often not politically favorable as it usually involves tax increases and government spending cuts that may include less transfer payments. Inflation also impacts on governments through Australias external stability. The lower international competitiveness associated with inflation means less exports leading to depreciation in the Australian dollar which can have a negative impact on the Current Account Deficit. Although the economic effects of inflation are mainly negative, there are two possible advantages of inflation that need to be considered. Firstly, borrowers with fixed interest rates will be advantaged as the rate of real interest they have to repay on their loan becomes effectively lower. For example, if an individual borrows at a fixed rate of 6% and inflation is 7%, then they are effectively paying negative real interest if there income keeps up with inflation. Secondly, by maintaining a small amount of inflation in an economy, deflation is avoided. Deflation is often more damaging to an economy as people constantly await decreases in price and hold back on consumption and investment creating a downwards spiral in prices.

Inflation has experienced mixed trends of recent years and the RBA has generally been effective in maintaining a sustainable inflation rate after high inflation in the 1980s. Clearly, inflation can be caused by a number of factors in the economy and will often disadvantage individuals, firms and governments whilst bringing some limited advantages.