Low Inflation

Demand Factors affecting Australia’s Rate of Inflation (2)

Of course there are many other demand side factors which can have an impact on the rate of inflation in Australia. Some of these are considered in the table below:

Demand Factor	Theoretical Link to Inflation	Evidence
Interest rates	When interest rates are increased the discretionary income of consumers and businesses will decrease. As a result, we may see decreased spending on consumption items (C) and business investment (I), and hopefully reduced pressure on the rate of inflation. Monetary policy is the major weapon used to fight inflation, and so it is believed that changes in the cash rate can have a very significant impact on this goal.	On the 5th of March 2008, the cash rate was increased to 7.25%. This is the highest interest rate that has been set by the Reserve Bank in quite some time. When the cash rate is increased, it is often true that there will be a short impact lag before a change in the inflation rate is seen. It is not surprising, therefore, that by June 2009 the inflation rate had fallen to 1.5% - this is the lowest rate that has been recorded in the last five years.
Business Confidence	As business managers become more confident they will also be more willing to invest in the future. This may mean an increase in investment spending (I) and hence an increase in aggregate demand.	Business confidence increased dramatically as demand from India and China drove economic activity in this country during 2006/07. By 2007 the NAB Business Confidence index suggested that sentiment in this sector had increased from 2.6 in 2005 to 10.9 in 2007. As a result, in 2007/08 inflation peaked at 4.5%.
Consumer Confidence	When consumers are more confident they are more likely to spend (C), and this can place pressure on the productive capacity of the economy. This demand side factor may lead to an increase in prices	Consumer confidence reached 121.5 on the Westpac Index during 2007. This was a significant increase on the previous year, when the infdex had fallen as low as 90. The increase in confidence resulted in a strong increase in consumption spending. As a result, inflation peaked at 4.5% in the following year.
The value of the Australian dollar	Changes in the value of the AUD will affect the willingness of people and businesses overseas to purchase our exports. If the AUD depreciates, this will lead to our products appearing relatively cheaper on the international market, and therefore our exports will increase. This equates to an increase in aggregate demand, and this in turn may place pressure on domestic prices (particularly amongst export orientated businesses).	During 2008/09 the Australian dollar went through a period of significant volatility. At the beginning of 2009 the AUD depreciated in response to the global financial crisis. This helped to stimulate demand for Australian exports. As a result, by the end of 2009 the RBA was forced to start increasing the cash rate in an attempt to prevent the resulting increase in inflation.
Income Tax Rates	If income tax rates fall, consumers will have a higher disposable income. Even though their actual pay has not changed, they will have more money to take home. This will lead to higher levels of consumption spending (C) and therefore higher levels of aggregate demand. Once again, this may put pressure on prices in the domestic economy.	Income tax rates were lowered as part of the budget process in May 2009. This resulted in an increase in consumption spending. As a result, while many other countries in the world were grappling with the possibility of deflation, the Australian economy became only the second in the world (after Israel) to increase interest rates to try and avoid inflationary pressure during this period.
Overseas Economic Conditions	If our major trading partners are experiencing strong economic conditions, then it is likely that they will demand more of our exports. The increase in demand for these goods and service will lead to an increase in aggregate demand, and pressure on the Australian price level.	During 2009 both the US and Japanese economies moved through a recessionary phase of the business cycle. This created some uncertainty in the export sector, and prices were often reduced to try and attract business. Overall, the rate of inflation fell to 1.5% by mid 2009.

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