Low Inflation

The Importance of Low Inflation

There are many people who would argue that achieving low inflation is one of the most important economic goals. This view has developed because when we fail to achieve low inflation the impact on living standards is dramatic.

Real Wages

The most important impact of high inflation on households is on our spending power. Imagine a situation in which your wage stays the same from one year to the next, but inflation is 5%. What would this mean for your standard of living?

The short term impact is that one of two things would happen. If you were previously able to save some money, the change in the general price level would mean that you are no longer able to save as much money. On the other hand, if you were already spending all of the money that you received, then inflation of 5% would mean that you have to stop buying some of the things that you buy.

In either case, what we have seen is known as a change in your real wage. Your nominal wage is the actual amount of money you receive. A far more important statistic is your real wage. To get this figure, economists will take your nominal wage and adjust it for the rate of inflation. Consider this example: If your employer offered you a 10% pay increase, would you be happy? The answer is that if the rate of inflation is 2%, then you would be very happy! As a result of the change in your wage you would be able to buy more goods and services, and therefore your standard of living would increase. On the other hand if the rate of inflation was 15% then a pay increase of 10% wouldn’t be enough. Despite the fact that you would be receiving more money, you wouldn’t be able to buy as many goods and services. This examples proves one key point – when you are thinking about changes to your wage, you must first stop to consider the prevailing rate of inflation.

Productive Investment

Inflation will also have a strong impact on the investment decisions that we make. When inflation is low, business owners will be encouraged to purchase capital assets, expand their operations, and try to increase their profits through increased economic activity. On the other hand, if inflation is high it might be easier to simply purchase an asset, and then wait for it to increase in value.

The first option is known as productive investment. When inflation is low, businesses are more likely to engage in productive investment. This means that our productive capacity will increase, more people will be employed, and the overall level of output generated by the business will be higher. As more goods or services are now being provided, we can see that productive capacity has increased. More products are available to people in Australia, and so more needs and wants can be satisfied. Overall living standards will be higher.

On the other hand, the second option is known as speculative investment. A speculator is a person who tries to make a profit through circumstances rather than business acumen. In this case, rather than opening the new outlet, a high inflation environment will encourage the owners to use their money to increase their wealth in other ways. The end result is that productive capacity in the economy is not increased, and jobs are not created. Worst of all, we have not created a situation in which more finished products are offered to the public, and so we can’t satisfy more needs and wants. Given the prevailing inflation, living standards will be lower.

International Competitiveness

Inflation can act to make our exports less attractive. We refer to this as our international competitiveness. Consider 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 it. 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.

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