Inflation targeting in Australia

From the mid 1950s up to the mid 1960s there was positive inflation in Australia. Late 1960s up to the 1970s saw an increase in inflation rate, which reached its peak at 17? percent in 1973 due to the oil crisis (http://www/rba. gov. au). The inflation rate from the 1950s up to the year 2002 is as follows. Inflation Year Ended After the 1982-83 recession it reduced to around 5% but the currency depreciation in 1985-86 led to its increase (http://www. rba. gov. au). On October 20th 1987, the stock market crashed causing a $55 million value at the market capitalization to be lost (http://www.

treasurer. gov. au). The monetary policy was eased while liquidity was loosened and from then on the interest rates increased and by 1959 were up to a bout 18% while the business overdraft rates were over 21% by early 1990. This led to a recession in the 1990-1991 period, which caused the loss of over 300,000 jobs, and this went on for the next 4? years. When the inflation came down, there was need to keep it that way and thus the adoption of the inflation target in 1993.

Inflation target is defined as a guide to the monetary policy in getting a range within which the prices will increase over a period (http://tutor2u. net). In Australia, the inflation target is 2-3% per annum. By 1992, the inflation rate was 2% and there was need to keep it that way. Inflation is defined as when money losses value in terms of its purchasing power. It is mostly caused by the aggregate demand being more than the aggregate supply or an increase in competition for scarce goods. Recession means a slowing down of a nations economy or its production.

It also relates to increased unemployment rates while interest rates are falling due to decreased demand for money. With this in mind, there is need to evaluate what would have happened in Australia in the absence of an inflation target. If the economy is at full capacity or operating very near potential GDP, then an increase in aggregate demand will lead to an increase in price with little output increase. This form of inflation is known as demand-pull inflation (http://wps. prenhall. com) Aggregate output (income) Y

Without inflation target the expectations of employees and businessmen will be very high. The employees expect their pay to grow at the same rate as the inflation to counter the effects of price increase. Businessmen on the other hand will demand a high return rate for their businesses. An increase in expectations among the people leads to a leftward shift of the aggregate supply curve thus increasing price and reducing output levels. To increase level of output the prices must be high and this leads to cost-push inflation.

The prices are increased to be an incentive to the producers to increase their output. When operating using an inflation target, an economy gains a lot of advantages. To begin with, it has the ability to reduce the cost-push inflation, it leads to higher levels of capital investment especially in the manufacturing and also in the service industries and also the businesses will not have high expectations built into their system leading to increased prices and thus inflation. The consumers are also enlightened on inflation and can hence understand the reason for the slow growth of pay.

This is the reason why cost-push inflation is reduced. There are however, some disadvantages to inflation target use. There is a danger of an increase in inflation depending on the inflation rate of the other countries or on the increase in import prices, which then increases interest rates thus decreasing economic growth causing unemployment. The nation can also operate at a productive level below its potential in the long run (http://tutor2u. net). Q2 Cost-push inflation is caused by the supply side. It is when output is decreasing while prices are rising.

Aggregate output (income) Y This form of inflation is very had to control with monetary policy. When operating at full capacity or near it an increase in the aggregate demand leads to an increase in price with little increase in output. In the long run, the aggregate supply is vertical thus neither monetary nor fiscal policy has any effect. This is because the “multiplier effect of a change in government spending or taxes on aggregate output is zero” (http://myphiliputil. perarsoncmg. com) Aggregate output (income) Y

For the economy to counter the loss of output, it has to provide incentives to the producers so that they can produce more. The only way this can be done is by increasing price levels at a rate that cannot be controlled by any policy action. This then makes it very hard to control this form of inflation because of the economy to grow there has to be production to avoid recession. The lack of a policy to govern the economy especially an inflation target means that the expectations of the consumers and producers are high.

The firms increase their prices leading to a demand of increase in salaries by the consumers thus causing increase in prices again to ensure the producers maintain their return rates. This shows that it is very hard for the inflation emanating form the supply side to be controlled by any policy.

References:

Aggregate Demand, Aggregate Supply and Inflation 2007. Retrieved on 13th Sept. 2007 from http://wps. prenhall. com/bp-casefair-econf-7elo,8233,2032169-00. htm Case K. & Fair R. 2002. Principles of Economics, Prentice Hall Business Publishing. Retrieved on 13th Sept.