Inflation

The Policy Approach

As you have seen, high inflation can result in several negative consequences. Lower real wages, a lack of productive investment and the possibility that our international competitiveness will be eroded are all very good reasons for the Australian government to work towards maintaining a very low rate of inflation in this country.

This is one of the very few economic goals where the government has published a statistical goal. Through the policy actions that are available, the government would like to see the average rate of inflation remain between 2% and 3% per annum over the course of the medium term. In Economics, the “medium term” suggests a period of seven to ten years, which is roughly equivalent to the length of the business cycle.

Supply Side Policies

The government is aware that to avoid inflation it is necessary to always try and find ways to increase the productive capacity of the economy. In the past they have tried a number of strategies to achieve this goal. It is important to remember that supply side policies are generally long term in nature; it would be ineffective to respond to the occurrence of high inflation with a supply side response, as this (on its own) would take too long to have the necessary impact.

For example, the government has received a review into the Australian taxation system that was written by the Secretary of the Treasury, Mr Ken Henry. This report is likely to shape the changes that will be seen to our tax system for many years to come. Chief amongst the suggestions that were included in that report was to structure the tax system to encourage investment in our productive capacity. While the government’s response will change over time, this could include reducing the company tax rate (which will reduce business costs), or provide attractive deduction rates for businesses that choose to invest in the latest technology (increasing efficiency). Changes like this should result in an increase in our productive capacity, and therefore lower rates of inflation in the future.

Demand Side Policies

Managing demand is important There is no doubt that the link between demand side policies as the response to high inflation is significantly more apparent to both the government and the general public. For many years now the government has engaged the Reserve Bank to implement monetary policy to control the rate of inflation in this country. Any move by the RBA is keenly anticipated by the public, which could account for the increased awareness.

Monetary policy is a topic that you will study in more detail in Unit 4. For now it is sufficient to remember that monetary policy is implemented when the RBA acts to change the cash rate. The cash rate is a special interest rate; it is the rate that the banks must pay when they borrow money in the overnight money market. When this rate is increased the banks are forced to pay more to borrow money. This encourages them to increase the rate that they charge their customers. In other words, any movement in the cash rate will ultimately be reflected in changes to the interest rates that people and businesses pay on loans that we have.

Now imagine a situation in which the Australian economy was experiencing an increase in the rate of inflation. To overcome this problem, the RBA might act to increase the cash rate. When this happens, people who have borrowed money will now need to make larger repayments. With more money flowing towards the financing of debt, less money is available to be spent on goods and services. In this way, both consumption and investment spending will be lower. As a direct result, over time we can expect to see the demand side pressure on productive capacity reduced. Although there is an impact lag associated with the use of this policy (which means that it can take some time to take effect), through this mechanism the RBA is able to control the rate of inflation.

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