Inflation Essay

Inflation Essay – Sam Toohey – Yr 11 economics
Causes and Consequences 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.
Below are the Inflation figured recorded every march, June, September and December from 2001-
2010
Year Mar Jun Sep Dec Annual

2010 2.8881% 3.0539%
2009 2.4661% 1.4581% 1.2613% 2.1084% 1.8201%
2008 4.2416% 4.5079% 4.9811% 3.6852% 4.3526%
2007 2.4358% 2.0739% 1.8626% 2.9582% 2.3324%
2006 2.9831% 3.9757% 3.9386% 3.2537% 3.5385%
2005 2.3595% 2.4862% 3.0261% 2.7986% 2.6687%
2004 1.9816% 2.4770% 2.3223% 2.5910% 2.3436%
2003 3.4407% 2.6890% 2.5993% 2.3656% 2.7707%
2002 2.9390% 2.8401% 3.2042% 3.0281% 3.0032%
2001 5.9904% 6.0222% 2.5210% 3.1226% 4.3808%
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.
Therefore we can see inflation is cause for a number of reasons (such as Demand Pull inflation and
Cost – Push Inflation) and how it effects the Australian Economy, the firms and the Individual within
our economy.

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What are the different types of inflation discussed?

What are some of the consequences of inflation?

Inflation Essay – Sam Toohey – Yr 11 economics

Causes and Consequences of Inflation

The Causes of Inflation

Demand-pull inflation can be caused by increases in consumption, investment, money supply,

The Effects of Inflation

Year Mar Jun Sep Dec Annual

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