Inflation

Aggregate Supply Factors

High business costs cause inflation You have just seen that an increase in aggregate demand can add to demand side pressures. In contrast, it is a decrease in aggregate supply that could result in an increase in inflation. While demand side factors result in pressure on productive capacity, supply side factors affect capacity directly. In broad terms, when aggregate supply increases we will have greater productive capacity in the economy, and therefore the probability of inflation will be reduced. On the other hand, when supply side conditions are poor capacity will be restricted, and it is possible that we will experience an increase in inflation at this time.

It is easy to discount the importance of supply side factors when you are thinking about inflation. This is especially true when you begin to examine the way in which economic policies are implemented to try and alleviate the problem of high inflation. Despite this, supply side conditions are actually crucial to the achievement of a low inflation environment. Both the Reserve Bank of Australia and the government are happy to see strong demand side conditions, but only to the extent that inflation is within the acceptable range. If aggregate supply is increasing, then demand is free to increase as well. On the other hand, when supply side conditions are poor policies will need to be put in place to restrict any increase in aggregate demand. In other words, you can think of supply side conditions as the “speed limit” of the economy.

There is a long list of supply side events that could result in an increase in the rate of inflation. Once again it is important to remember the skills that you learned earlier in your study of Economics; while there are many factors, each one must be linked to the economy as part of your analysis. For example:

Availability of Resources: It is now very rare to find new supplies of oil. With supply restricted in this way, it is not surprising to see an increase in the price we pay for a litre of petrol. When the country is experiencing a drought, the lack of water will mean the crop yield is lower, and the price we must pay for farm produce will increase. It is also true that the availability of labour can result in a higher rate of inflation. When the participation rate falls overall productive capacity is lower, which can lead to an increase in inflation.

Costs of Production: Any increase in business costs will normally be passed on to consumers. As soon as this happens, it is more likely that we will see an increase in the rate of inflation. For example, higher prices for raw materials such as oil and timber, or an increase in wage rates could both lead to cost inflation. It is also true that a depreciation of the Australian dollar could result in supply side inflation. Many Australian businesses import products from overseas; when the value of the AUD falls, it will cost more to purchase these items, and as a result inflation is more likely. (Note that you should not use interest rates as a business cost that will result in a higher rate of inflation. You will learn more about this fact on the next page.)

Efficiency: Businesses always strive to find ways to become more efficient. When they are successful, productive capacity increases and the pressure on inflation is reduced. On the other hand, when businesses struggle to find ways to become more efficient it is likely that the rate of inflation will increase. This could occur when a process that could be done using technology is still being performed manually, or when productivity rates slip.

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