| 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.
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The cash rate was increased in the first half of 2000, and as a result the rate of inflation peaked at 6.0% in that year and then moved down quickly. On the other hand, between December 2003 and March 2005, the cash rate was left unchanged at 5.25%. Some have argued that this was a slightly expansionary stance, and inflation was allowed to increase slightly during this period. By 2006, inflation was above the goal range.
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| 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.
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According to the NAB Index, business confidence peaked at 21.2 in 1994/5. This corresponded with an increase in private business investment of 11% (the second highest for the period), and direct pressure on prices. At this time, the inflation rate increased from 1.8% to 3.2%. (Note: The second lowest rate of business confidence for the period corresponded to the highest rate of inflation – 2000/2001. In this case the pressure on inflation was predominantly due to supply side conditions.) Between 2002 and 2006 business confidence fell. In this instance the "cause" and "effect" were reversed - part of the reason for the fall in business confidence was the higher rate of inflation.
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| 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
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Consumer confidence reached 109 on the Westpac Index during 2001/2002. This was a significant increase on the previous year (101). As a result, the RBA responded with an increase in interest rates even though the inflation rate at the time was within the goal range. After 2001/02 consumer confidence continued to increase, and it eventually reached 120 on the index. As a result, inflation continued to increase despite the small increases in interest rates that were seen during this period.
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| 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).
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During 2000/2001 out Trade Weighted Index fell from 53.3 the previous year to 49.7. This resulted in an increase in demand for our exports, and corresponded with the highest rate of inflation for the period (6%). (The increase in exports in that year was 7.3% - the following year the TWI appreciated, and exports fell by 1.5%.)
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| 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.
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Private consumption expenditure increased by 3.0% in 2000/2001, despite the introduction of the GST. This is due in part to a cut in the rate of personal income tax, which contributed to the rate of inflation seen at that time (a peak of 6%). Further cuts to income tax rates between 2003 and 2006 resulted in similar increases in consumption spending, and therefore pressure on inflation increased during this period.
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| 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.
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During 2001/2002 the US economy grew only 0.8%. As a result, our exports during this period fell, and pressure on prices from the external sector was not as great. However, as the US economy moves out of this phase and returns to strong growth, the RBA has interpreted this as a possible demand side influence on future prices, and interest rates were increased twice at the end of 2003 to combat this at a domestic level.
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Unit 1
Unit 3
