Low Inflation

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

Supply Factor	Theoretical Link to Inflation	Evidence
Interest Rates	When interest rates increase producers will need to use more of their revenues and profits to repay existing loans. As such any increase in the cash rate will lead to higher costs of production, and this in turn may mean a decrease in aggregate supply.	Interest rates have a stronger impact on aggregate demand than they do on aggregate supply, and as such they are used as the major weapon to fight demand side inflation. Despite this, it is possible that the increase in interest rates during late 2007/early 2008 (up to 7.25%) contributed to the inflation rate of 4.5% recorded in that year.
Wages	Wages are another very significant cost of production. When wages increase businesses are faced with the prospect of paying more to produce the same level of output. Once again, with the increase in production costs it is possible that aggregate supply will decrease.	The wage price index has been relatively stable over the last five years. However, in 2008/09 the pressure on wages was slightly reduced, with a figure of 3.8% being recorded. This may have contributed to the lower rate of inflation (1.5%) that was seen in mid 2009.
The Exchange Rate	As the value of the Australian dollar decreases, aggregate supply may fall. Around 80% of all imports are used in the production process, and so when the dollar is weak it costs more to purchase these productive imports. This equates to higher costs of production, and hence aggregate supply may decrease.	The TWI has remained consistently high for several years now, and this has helped to keep inflation in this country within the goal range. For example, the recovery in the value of the Australian dollar during 2009 (the TWI increased from 53.2 to over 70 during this period) helped to ensure that inflation was recorded below the goal range during that year.
Productivity Gains	When businesses are more productive the pressure on aggregate supply is reduced, and the impact on inflation may be positive. However, if productivity gains are not able to be sustained, this may lead to a decrease in aggregate supply, and subsequently cost inflationary pressures in the economy.	In 2008/09 labour productivity in Australia was very poor. In fact, labour actually increased by only 0.4% in that year. Supply side concerns such as this contributed to the RBAs decision to increase the cash rate to fight off future inflation by the end of 2009. This decision was made even though the rate of inflation at the time was below the goal range.

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