The Government

The Australian government has recognised the importance of maintaining a low inflation environment for many years.  It is not surprising, therefore, that they have worked to influence both demand and supply side conditions to try and ensure that inflation is maintained at an acceptable level.

In 1996, the newly elected Liberal government legislated to enable the Reserve Bank of Australia to implement monetary policy to keep the rate of inflation between 2% and 3% per annum over the course of the business cycle.  Although it will be very difficult to ensure that the annual rate of inflation falls exactly in this band each year, the policies that have been implemented have been very successful in ensuring that the average rate has fallen right in the middle of this range.  You will learn more about the way in which monetary policy works on the eighth page of this section.

Inflation is a key factor that can result in a government being voted out of office.  Generally speaking if the rate of inflation is low, more often than not the incumbent party will be returned to government.  On the other hand, when inflation is very high it is very unlikely that the government will retain office after an election.  Most people are surprised to discover this fact, and so it is worthy of further explanation.

You have already seen that high inflation can erode real wages, and that when inflation is high productive investment is discouraged.  If businesses are investing in their productive capacity, they won’t be creating new jobs.  This can lead to an increase in the unemployment rate.  In the short term governments will normally face a trade off between employment and inflation; a high inflation environment is more likely to occur when jobs are being created.  But in the medium to long term high inflation will result in fewer job opportunities.  Most importantly, the country will be unable to generate employment in the so called “new economy”.  For example, jobs that are dependent on a large investment in new technology can only be created when businesses are willing to purchase the necessary equipment, and that will only happen in a low inflation environment.  In a country like Australia this tends to affect our willingness to purchase super-computers or particle colliders.  On the other hand, rampant inflation in Zimbabwe means that in that country it is almost impossible to gain access to a calculator.

The government is also aware that the long term prosperity of a country like Australia in the modern world is largely based on our ability to generate exports.  We live in a globalised society, and this means that we rely on our ability to access imported goods and services, as well as the income that we generate from selling our products to people and businesses overseas.

Inflation can act to make our exports less attractive.  We refer to this as our international competitiveness.  Imagine a situation in which two countries sell wheat, and in the first year the price of wheat is exactly the same regardless of where you buy the wheat.  However, in one country the rate of inflation is 10%, while in the other country the rate of inflation is 1%.  What will happen?  Over time, the high inflation country will find that they can no longer compete with the low inflation country.  This will mean that they don’t need to grow as much wheat, and so some fields may become idle.  The income of the farmers in that country will fall, and therefore so will their standard of living.  Eventually some may find that they are forced out of business altogether.

On the other hand, the low inflation country will see an increase in their sales.  This will encourage them to invest in new technology, or find new areas that can be used to grow wheat.  The income for farmers will increase, which will encourage them to increase their spending in other areas.  For example, the farmers might find that they can send their children to private schools, which will create new jobs for teachers and other support staff in the relevant schools.  Eventually, these benefits will flow through to everyone in the economy.