Price Stability

Demand Factors affecting Australia's Rate of Inflation

Any increase in aggregate demand will place pressure on the productive capacity of the economy, and as a result demand side inflation may occur. As such we can predict the possible occurrence of demand inflation by using the model of the market mechanism.

Here we can see that any factor which will cause an increase in aggregate demand may lead to inflation in the Australian economy. An example will make this clear. We will consider the demand side impact of changes in wages on the rate of inflation.

In theory, when wages increase the consequences may be an increase in consumption spending. This is because consumers (who receive the wages) will probably choose to spend some or all of the increase in disposable income that they receive. In so doing they will add to aggregate demand.

Inflation vs the wage price index in Australia

In the graph above we can see that there is some correlation between changes in wages and the rate of inflation. As the increase in wage rates has grown, the inflation rate has followed a similar trend. Similarly, when the increase in wages was smaller, the demand side pressure on prices was smaller. Therefore the inflation rate was able to trend down.

This is particularly evident in the period after 2004/05. As the wage cost index increases to be over 4.0%, the pressure on inflation is evident. It is far more difficult for policy makers to maintain an acceptable rate of inflation when wage pressures are high. Today, the Rudd government is very concerned about the possibility of a "blowout" in wage claims, partly because they are aware that this will have a detrimental affect on the rate of inflation in this country.

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