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Chapter 9
Inflation

THE MEASUREMENT OF INFLATION

Inflation refers to a sustained increase in the general price level over time. It is the opposite to deflation
where there is a sustained decline in the general price level over time. For the government to achieve the
goal of price stability, inflation must be kept at or near zero. The price level is the average level of prices
in the economy and is measured by calculating a price index. In Australia, the most widely quoted price
index is the Consumer Price Index (CPI), which measures changes in the prices of a selected regimen
of consumer goods and services over time using price index numbers. With reference to the CPI it is
possible to measure the annual rate of inflation by using the following formula in equation (1):
(1) Inflation Rate = Current Inflation - Previous Inflation 100
Previous Inflation x 1
To calculate the inflation rate in the Australian economy between Year 1 with a CPI of 120 and Year 2
with a CPI of 129 we need to find the percentage change in the price level between these two years i.e.
Inflation Rate = 129 - 120 100
120 x 1 = 7.5%
This result can be interpreted as Australia having an inflation rate of 7.5% between Years 1 and 2.

Headline Inflation
The quarterly rate of change in the CPI is called the headline rate of inflation. It measures price
movements in a selected regimen of household expenditure. Changes in the quarterly CPI are widely
reported by the media and this is why it is known as the headline rate of inflation. The CPI consists
of eleven categories, each with different weights: food (16.8%), clothing and footwear (4%), housing
(22.3%), household equipment (9.1%), transport (11.6%), alcohol and tobacco (7.1%), health (5.3%),
recreation (12.6%), education (3.2%), communication (3.1%), financial and insurance services (5.1%).
In Table 9.1 changes in eight of the eleven CPI categories of expenditure are shown between 2008-09
and 2011-12. The CPI series is a weighted average of price movements in Australia’s eight capital cities.
Each regimen item is weighted by its importance in average household expenditure and the rate of
change in all groups is used to construct the CPI. Expenditure is compared with a base year (which is
given an index number of 100), and an index number series is constructed for CPI inflation.

Table 9.1: Consumer Price Index by Group 2008-09 to 2011-12 (June qtr 2005 = 100)

Year Food Clothing & Housing Household Transport Alcohol & Health Recreation All Groups
Footwear Equipment Tobacco (11 in total)

2008-09
186.5 110.2 149.0 125.1 163.7 263.6 245.4 137.1 166.4
2009-10
189.5 109.9 157.6 128.0 164.9 276.3 257.2 137.7 170.3

2010-11
196.5 107.7 165.3 127.9 168.5 303.3 269.0 136.1 175.6

2011-12
197.9 109.3 171.5 128.3 174.0 313.6 279.1 135.5 179.7
Source: ABS (2012), Consumer Price Index, Catalogue 6401.0, June.

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Each quarter (March, June, September and December) the ABS releases quarterly and annual changes
in the CPI. In the June quarter 2012, CPI inflation rose by 0.5%. The annual percentage change in the
CPI from the June quarter 2011 to the June quarter 2012 was 1.2%. This was calculated by rounding
the percentage change in the CPI from the June quarter 2011 to the June quarter 2012 as follows:
Headline Inflation Rate in 2011-12 = 180.4 - 178.3 100
178.3 x 1 = 1.2%
The CPI measure of inflation is monitored by the Reserve Bank of Australia (RBA) for achieving its
inflation target of 2% to 3% average consumer price inflation over the economic cycle. This target is
used to conduct monetary policy in achieving the goal of price stability. The advantages of using the CPI
measure of inflation as the RBA’s inflation target are its simplicity, and widespread public recognition
and understanding of the CPI as a measure of quarterly and annual inflation in the Australian economy.

Underlying Inflation
The underlying rate of inflation or ‘core’ inflation is a calculation of inflation that removes ‘one off’
and seasonal or volatile factors (such as higher food prices due to droughts, floods or cyclones, higher
oil prices or government induced tax changes) from the CPI series. Underlying inflation is a better
indicator of trend or core inflation in the economy than CPI inflation because quarterly CPI statistics
can be volatile if distortions are caused by large price movements in one or two groups or categories of
expenditure. Underlying inflation is calculated by the Reserve Bank and Treasury and used in economic
forecasting. The Reserve Bank calculates three measures of underlying inflation from the CPI series:
1. The trimmed mean is an expenditure weighted average of the middle 70% of CPI price changes.
2. The weighted median is the price change in the middle of the ordered CPI distribution, also taking
expenditure weights into account.
3. The CPI excluding volatile items, removes seasonal price rises or falls, such as fruit and vegetables.

RECENT TRENDS IN INFLATION

Historically Australia has been a high inflation country. In the 1970s and 1980s inflation averaged
between 6% and 10%, but after the 1990-91 recession inflation fell to below 5%. It stayed below 3% in
both CPI and underlying terms for most of the 1990s and 2000s (see Figure 9.1). Australia’s inflation
rate averaged 2.7% between 1994 and 2012, slightly above the OECD average of 2%. This improved
Australian inflation performance was due to a number of factors which reduced demand and cost
pressures, and eliminated the wage-price spiral which eroded Australia’s competitiveness in the 1980s:
• The adoption by the Reserve Bank of an inflation target in 1993 for the operation of monetary
policy, provided an anchor for inflationary expectations, and made the conduct of monetary policy
more transparent, credible and effective in controlling inflation in the Australian economy;
• The exposure of the Australian economy to increased levels of competition in product and factor
markets through cuts in protection (1988 to 2010) and the implementation of the national
competition policy in 1995 put downward pressure on the price level in product markets;
• The adoption of productivity bargaining in 1991 as a principle in wage negotiations in reaching
workplace agreements, helped to contain wage cost pressures in the Australian labour market;
• The permanent lowering of inflationary expectations through the successful conduct of
macroeconomic policy helped to improve economic performance and lower prices; and
• The impact of technological change and globalisation helped to reduce production costs (through
economies of scale) and increased competitive pressure on all firms to contain price rises.
There was however an upsurge in inflation between 2006 and 2008 due to the resources boom and
increased wage pressures, with the CPI rising by 4.5% and underlying inflation by 4.3% in 2007-08.
Trends in CPI and underlying inflation between 2001-02 and 2011-12 are shown in Figure 9.1.

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Figure 9.1: CPI and Underlying Inflation in Australia 2001 to 2012 (annual % change)

%
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
01-2 02-3 03-4 04-5 05-6 06-7 07-8 08-9 09-10 10-11 11-12

CPI Underlying OECD Average

Source: ABS (2012), Consumer Price Index, Catalogue 6401.0, June.

The higher inflation rate in 2007-08 changed with the impact of the Global Financial Crisis and
recession in 2008-09. This led to lower global commodity prices such as oil and food, and declining
global inflation. Inflation also moderated in the Australian economy, with the CPI rising by 1.5%
in 2009. The low CPI outcome was driven by lower prices for fuel and deposit and loan facilities.
However a strong economic recovery in 2009-10 and the impact of floods and Cyclone Yasi in late 2010
and early 2011 led to higher fruit and vegetable prices which lifted CPI inflation to 3.6% in the year
ended the June quarter 2011 (see Table 9.2). Measures of underlying inflation rose to 2.7% in 2011.
In the year ended the June quarter 2012 headline inflation eased to 1.2% and underlying inflation to
around 2%. This was due to lower food prices, softer demand for some goods and services, and the
effect of exchange rate appreciation putting downward pressure on the price of many imported goods.
Tradables price inflation (i.e. the extent of price rises for imported goods and services) only rose by
0.1% in the June quarter 2012 but was 2% lower over the year as shown in Table 9.2. This was mainly
due to the disinflationary influence of the strong exchange rate on import prices.

Table 9.2: Measures of Consumer Price Inflation in 2011-12 (%r)

Measure Year Ended Year Ended

June Quarter 2011 June Quarter 2012

Consumer Price Index (CPI) 3.6 1.2

– Tradables 3.6 -2.0
– Non Tradables 3.5 3.3
Underlying Inflation Measures
– Trimmed mean 2.7 2.0
– Weighted median 2.7 1.9
– CPI excluding fruit, vegetables and automotive fuel 2.4 1.9
Source: Reserve Bank of Australia (2011 and 2012), Statements on Monetary Policy, August.

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Non tradables inflation (i.e. price rises for domestically produced goods and services) rose by 3.3% in
the year ended the June quarter 2012, slightly lower than the 3.5% rise recorded in the year to the June
quarter 2011. The modest slowdown in non tradables inflation was broad based across a range of goods
and services including food, new dwellings, domestic travel and accommodation. The main factors
responsible for the moderation in inflation between 2011 and 2012 were the following:
1. Lower food prices, especially for fruit and vegetables, because of the return to normal supplies after
the disruptions caused by the Queensland and Victorian floods and Cyclone Yasi in 2010-11.
2. The impact of the high value of the exchange rate in reducing the prices of many tradable goods
and services including travel, motor vehicles and electronic goods.
3. Softer demand for new housing which led to lower purchase costs of new dwellings.
4. A moderation in the Wage Price Index (WPI) from around 4% in 2010-11 to 3.7% in 2011-12
which helped to contain labour costs in most industries.
In the 2012 budget the Treasury forecast CPI inflation of 3.25% and underlying inflation of 2.5% in
2012-13 (refer to Figure 9.2). These forecasts were based on a ‘one off’ carbon price impact of 0.7% on
the headline rate of inflation and 0.25% on the underlying rate of inflation in 2012-13.

Figure 9.2: Trends in Headline and Underlying Inflation 2004 to 2014 (f)

Source: Commonwealth of Australia (2012), Budget Strategy and Outlook 2012-13. NB: tty is ‘through the year’

THE CAUSES OF INFLATION

The major causes of inflation are pressures that can come from both the demand and supply sides of
the economy. Inflation may arise from excessive growth in total expenditure or aggregate demand. If
the economy’s level of aggregate spending exceeds aggregate output or GDP, there will be pressure for
the price level to rise to ration the available output amongst competing consumers. This is known
as demand pull inflation, since excess aggregate demand is said to ‘pull prices up’. This occurred in
Australia in 2007-08 as full employment was reached, and demand pressures led to higher inflation.
In Figure 9.3, the equilibrium level of national income is Ye, determined by the intersection of the
aggregate demand (AD) and aggregate supply (AS) curves. J. M. Keynes argued that the equilibrium
level of income may not coincide with the full employment level of income of Yf in Figure 9.3. If total
spending exceeded the full employment level of the economy’s income, an inflationary gap of cd would
arise, causing inflation to rise, leading to a higher price level and a fall in purchasing power.

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Figure 9.3: Keynesian Inflationary Gap Figure 9.4: The AD/AS Inflationary Gap

Expenditure Price Level

AD1
AS Inflationary Gap AS
AD
Inflationary
Gap AD
c d
P1
d
P
c

0 450 0
Yf Ye Income real real Real GDP
GDP1 GDP 2

Figure 9.4 illustrates how demand pull inflation may occur using the AD/AS model of the economy. The
economy’s price level is measured on the vertical axis, whilst real GDP is measured on the horizontal axis.
Aggregate demand (AD) is the sum of spending on consumption (C), investment (I), net government
spending (G), and net exports (X-M). Aggregate demand is negatively sloped since the economy will
only buy more output at a lower price level. Aggregate supply (AS) is equivalent to the economy’s real
GDP and is positively sloped since more output is supplied at higher price levels.
The economy’s equilibrium price and output level is found where AD and AS intersect at price level
P and real GDP1, which is the full employment level of real GDP or national income. If aggregate
demand increases from AD to AD1 because of a rise in a budget deficit, growth in export income, or
growth in consumer or investment spending, the price level will rise to P1, and real GDP will increase to
real GDP2, resulting in an inflationary gap of cd. The main causes of demand pull inflation are excessive
growth in any of the major components of aggregate demand (AD = C + I + G + X - M) such as:
• Increases in consumption expenditure (C) caused by higher consumer confidence, wage increases,
increased perceptions of wealth (through higher asset prices), tax cuts or falls in interest rates;
• Increases in investment spending (I) caused by higher profits, higher business confidence, tax cuts,
increased depreciation allowances or falls in interest rates;
• Increases in the money supply (Ms) caused by Reserve Bank action (such as interest rate cuts) to
stimulate the demand for credit, which can lead to increased consumer and business spending;
• Increases in net government expenditure (G) caused by a rise in the government’s purchase of goods
and services, or tax cuts, which lead to a larger budget deficit or a lower budget surplus; or
• Increases in export income (X) sourced from a higher terms of trade, causing higher incomes and
investment and consumption expenditure in the domestic economy.
The other major type and cause of inflation operates from the supply side of the economy and is known
as cost push inflation. Cost push inflation results from a decrease in aggregate supply and may be
caused by a rise in wage rates or a rise in the cost of raw materials such as oil and energy prices, or other
inputs into the production process. Figure 9.5 shows how cost push inflation can arise. The initial
equilibrium for the economy is at price level P and real GDP1. A decrease in aggregate supply from
AS (e.g. caused by an ‘across the board’ wage increase or an increase in the price of oil) will shift the
aggregate supply curve to the left to AS1. This will cause a new equilibrium to be established at a higher
price level of P1 and a lower level of output at real GDP2. The economy experiences both a contraction
in real GDP (i.e. less economic growth) and a rise in inflation as the price level has increased.

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Figure 9.5: Cost Push Inflation

Price Level
AS1
AS

P1
P

AD
0
real GDP2 real GDP1 Real GDP

This phenomenon is known as stagflation (i.e. lower growth, higher inflation and rising unemployment)
which first arose in the global economy in the 1970s. The major causes of cost push inflation are
increases in the costs of production. Since wages and other input prices are determined in factor
markets, any rise in the prices of the factors of production may lead to a fall in aggregate supply and a
rise in the economy’s price level. Some common sources of cost push inflation (i.e increases in costs are
said to ‘push prices up’) are as follows:
• Across the board wage increases for workers not reflecting improvements in labour productivity;
• A rise in the price of domestic or imported raw materials such as oil or manufactured components
or intermediate goods which raise production costs for businesses in the economy;
• A depreciation of the exchange rate which may raise the cost of imports such as capital equipment
and raw materials;
• A rise in government charges including taxes (e.g. the GST and carbon tax), freight rates, royalties
or workers’ compensation premiums which raise production costs for firms; or
• A rise in the general level of interest rates caused by a tightening of monetary policy which raises
the cost of borrowing and reduces firms’ cash flows.
A major cause of inflation in the world economy which affected Australia in 1973-74 and in 1979-80
was imported inflation. For example, the price of imported oil rose in 1973-74 and in 1979-80 due to
OPEC restrictions on world oil supplies. As a result energy prices rose, and also the final prices of goods
and services dependent on oil inputs such as the price of petrol and transport services in distributing
final goods and services to consumers. These were the ‘second round’ effects of higher oil prices. A
large depreciation of the Australian exchange rate in 1986 had a similar effect on the domestic prices of
imports. Importers passed on the impact of higher import costs to consumers through higher prices.
An example of how stagflation could have arisen in the global economy was the impact of a permanent
US$5 a barrel increase in the price of oil on world GDP after the invasion of Iraq in 2003 by the USA
and its allies. The IMF in 2003 undertook a study to estimate the effects of rising oil prices on world
GDP, and on industrial and developing countries, with the following results:
• World real GDP would contract by -0.3%
• The real GDP of industrial countries would contract by -0.3%
• The real GDP of developing countries would contract by -0.2%
In addition, the IMF estimated that trade balances would deteriorate, and price levels would increase by
some 2% to 3% after one year of absorbing the oil price increase of US$5 a barrel.

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REVIEW QUESTIONS
THE MEASUREMENT, TRENDS AND CAUSES OF INFLATION

1. What is meant by inflation? How are inflation and the inflation rate measured in Australia?

2. What is the CPI? Refer to Table 9.1 and explain how the CPI is constructed.

3. Distinguish between the headline and underlying rates of inflation.

4. Refer to Figure 9.1 and the text and discuss Australia’s recent inflation performance.
Why did Australia record relatively low rates of inflation in the 1990s and 2000s?

5. Explain why Australia experienced rising inflation after reaching full employment in 2007-08.

6. Explain why inflationary pressures fell in Australia in 2008-09 but rose in 2010 and 2011.

7. Refer to the data in Table 9.2 and describe and account for trends in headline, tradable, non
tradable and underlying inflation between 2011 and 2012.

8. Refer to Figures 9.3 and 9.4 and the text and explain the main causes of demand pull inflation.

9. Refer to Figures 9.5 and 9.6 and the text and explain the main causes of cost push inflation.

10. Discuss the causes and effects of stagflation and imported inflation.

Inflationary Expectations and the Phillips’ Curve

In analysing the causes of inflation it is important to note that the economy can experience demand
pull and cost push inflation simultaneously through a wage-price inflation spiral. If excess aggregate
demand leads to demand pull inflation, wage earners may anticipate a rise in the price level and seek
higher nominal wages to maintain their real wages. If they are successful in gaining a wage increase,
this may lead to a fall in aggregate supply and further rises in prices. If aggregate demand continues
to increase, further price and wage increases may occur, leading to an acceleration in inflation. This is
known as runaway or galloping inflation and may lead to hyper-inflation such as that experienced in
the German Weimar Republic in the early 1930s when inflation was in excess of 1000% per annum. A
recent example of hyperinflation occurred in Zimbabwe after the collapse of its economy in 2004-05.
Higher inflation that results from a wage-price
spiral may be caused by an increase in inflationary Figure 9.6: The Short Run Phillips Curve
expectations. Inflationary expectations refer
to people’s perceptions of future inflation based
on past and current rates of inflation. The New
Zealand economist, A. W. Phillips, observed a Inflation %
tradeoff or inverse relationship between inflation SRPC
and unemployment in the short run in Britain
in the 1950s. This short run tradeoff is shown
5%
in Figure 9.6. A government in attempting to
reduce unemployment below 4%, by increasing 2%
government spending, could trade off more 0%
inflation (2% to 5%) for less unemployment (4% 3% 4 % Unemployment %
to 3%). Alternatively a government might cut
government spending to trade off less inflation
(5% to 2%) for more unemployment (3% to 4%).

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This short run tradeoff tended to disappear in

the 1970s as stagflation (i.e. high inflation, high Figure 9.7: The Long Run Phillips Curve
unemployment and low growth) was experienced
by industrial countries (due to higher oil prices), Inflation %
and governments had problems in attempting SRPC 2 LRPC
to trade off inflation with unemployment. SRPC1
SRPC
The explanation for the lack of this tradeoff in
the long run was put forward by Friedman and 3% d e
Phelps in their expectations augmented Phillips’ 2%
b c
Curve illustrated in Figure 9.7, where three short
0% a
run Phillips’ curves (SRPC, SRPC1 and SRPC2) 5% 6%
represent an increase in inflationary expectations Unemployment %
over time. The Long Run Phillips’ Curve (LRPC)
represents the natural rate of unemployment. If
the economy was operating at point (a) with 6%
unemployment and zero inflation, and the government increased spending to reduce unemployment,
this would cause a rise in inflationary expectations to 2% and a fall in unemployment to 5% in the
short run at point (b). However workers would increase their wage demands as prices have risen,
reducing their real wages. Firms would cut back their demand for labour and unemployment would
move back to its natural rate of 6%, and the economy would operate at point (c) on SRPC1. Further
use of expansionary policies to reduce unemployment will only lead to higher inflation and no change
in unemployment i.e. the economy will move from point (c) to point (d), and to point (e) on SRPC2,
where inflation is 3%, but unemployment is unchanged at 6%. Hence Friedman and Phelps argued
that there was no trade off between inflation and unemployment in the long run, as an economy would
always return to its natural rate of unemployment. They argued that government attempts to reduce
unemployment by using expansionary macroeconomic policies would only lead to higher inflation, and
the way to reduce unemployment was to cut inflation and increase the flexibility of the labour market.

THE NEGATIVE AND POSITIVE EFFECTS OF INFLATION

Inflation is considered to be a macroeconomic problem because persistently high levels of inflation lead
to higher inflationary expectations. When people expect higher inflation in the future (based on their
past and present experience of inflation) they will build these expectations into their price and wage
negotiations. Thus inflation may become part of the ‘culture of doing business’, and countries may suffer
permanently high levels of inflation, leading to lower purchasing power, international competitiveness
and a misallocation of resources. The major negative effects of inflation impact on various groups in the
economy such as consumers, workers, producers, exporters, savers, investors and governments:
• Consumers suffer a loss in purchasing power and real income. Unless consumer incomes keep pace
with inflation, the cost of living continues to rise, reducing real incomes and living standards;
• Workers or wage earners suffer a fall in real wages if their money wages do not rise by the same
percentage as the increase in the rate of inflation and cost of living over time;
• Producers or businesses react to higher costs or excess demand by putting up prices. This may
lead to higher ‘menu costs’ as they adjust their prices. Producers may also react to higher costs by
reducing their work forces to cut labour costs, which may lead to higher unemployment;
• Exporters and import competitors (in the tradable goods sector of the economy) may find it
difficult to pass on higher production costs in the form of higher prices in markets, and may suffer
a temporary or permanent loss of international competitiveness in global markets;
• Savers will find that the real value of their savings will decline if nominal interest rates do not keep
pace with inflation. Lenders will demand higher nominal interest rates to compensate for the loss
in their purchasing power caused by inflation, which reduces the real returns on their loans;

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• Investors will find that the higher cost of borrowing will make some investment projects less
profitable and will reduce their demand for investment funds. Some investment decisions will be
distorted if asset prices (such as shares, real estate, bonds and derivatives) are rising faster than the
prices of other goods and services, leading to more speculative investment in financial assets rather
than economic investment in expanding productive capacity and technological progress; and
• Governments will find that the costs of providing goods and services will rise, causing an increase
in government expenditure. However, taxation revenue will also rise as taxpayers pay more tax on
consumer goods and services, and wage earners are pushed into higher tax brackets (i.e. ‘bracket
creep’). Government revenue will tend to rise because of ‘fiscal drag’ (i.e. higher tax revenue due
to higher prices and incomes), but spending will also rise due to the higher costs of providing
infrastructure, welfare payments and collective goods and services.
If the Australian government is not able to achieve the objective of price stability in the medium term
by containing inflation, there will be major macroeconomic costs of higher inflation as follows:
• A reduction in the purchasing power of consumers and producers and a fall in real incomes;
• A redistribution of income away from wage earners and fixed income earners to those receiving
profit and dividend income;
• A misallocation of resources caused by distortions in the price level and the cost structure;
• A loss in international competitiveness as export prices rise (relative to foreign competitors) and
import prices fall relative to the prices of domestically produced goods and services;
• A reduction in real savings and real investment which reduces the rate of capital accumulation;
• A rise in unemployment if firms substitute capital for labour because of wage inflation; and
• A deterioration in government budget outcomes and higher debt interest in the future.
The positive effects of inflation result from the impact of rising prices on asset prices such as shares and
real estate. If there is a speculative boom in the share market or real estate market, driven by excessive
levels of confidence and demand, this can lead to asset price inflation. Speculators can gain from asset
price inflation if they sell their financial or real assets at inflated prices before the inevitable collapse of
the speculative boom. However asset price inflation can lead to a distortion in resource allocation if
investment is in speculative assets rather than productive assets which yield real returns in the long term.

POLICIES TO REDUCE INFLATION

The Australian government uses macroeconomic and microeconomic policies to achieve sustainable
economic growth, which will allow real incomes to be increased whilst inflation is minimised. There
are two conventional tools of macroeconomic policy which can be used to reduce the rate of inflation:
• Contractionary monetary policy, through an increase in the official cash rate, leading to a rise in
term structure of interest rates in the economy, to contain the growth in aggregate demand; and
• Contractionary fiscal policy, through an increase in taxation or reduced government expenditure,
or a combination of the two measures, to contain the growth in aggregate demand or spending.
A tightening in the stance of monetary policy involves the Reserve Bank of Australia raising the cash
rate, leading to an increase in other short term and long term interest rates. This increase in interest
rates will lead to a reduced incentive for businesses to borrow and invest, and for consumers to borrow
and spend. There will also be a greater incentive for households and businesses to save (because of
higher returns) and retire debt. This will result in a decline in the growth of aggregate demand and
demand pull inflation in the economy. An example of the use of a more restrictive stance of monetary
policy to reduce inflation was the Reserve Bank’s seven increases in the cash rate of 0.25% from October
2009 (3%) to November 2010 (4.75%). Higher official interest rates led to rising market interest rates
and tighter monetary conditions in Australia. The effects of higher interest rates, were slower growth in
retail spending, a reduction in levels of debt, and reduced demand for credit from financial institutions.

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Alternatively, contractionary fiscal policy involves an increase in the structural surplus or a reduction
in the structural deficit of the budget outcome. Regardless of whether a reduction in the level of
government expenditure and/or an increase in the level of taxation is used to achieve the new fiscal
policy stance, the effect will be a reduction in the net injection of funds from the government sector (i.e.
net public demand) into the economy and a reduction in demand pull inflationary pressures.
An example of a more restrictive stance of fiscal policy to reduce inflationary pressures was the Gillard
government’s 2011-12 budget which aimed to reduce the growth of public demand and the fiscal
stimulus used to support the economy during the Global Financial Crisis in 2008-09. Total government
expenditure was forecast to increase from $349.7b in 2010-11 to $362.1b in 2011-12. However as a
percentage of GDP, government expenditure was forecast to fall from 25.2% to 24.5%. Furthermore
the automatic stabilisers in the budgetary framework were expected to see revenue grow from $303.7b
(21.9% of GDP) in 2010-11 to $342.4b in 2011-12 (23.2% of GDP). Overall the fiscal balance was
forecast to fall from a deficit of -$45.7b (-3.3% of GDP) in 2010-11 to a smaller deficit of -$20.3b
(-1.4% of GDP) in 2011-12. The underlying cash balance was also forecast to fall from a deficit of
-$49.4b (-3.6% of GDP) in 2010-11 to -$22.6b (-1.5% of GDP) in 2011-12.
The 2011-12 budget strategy was based on returning the budget to surplus by 2012-13 and reducing
public debt. The more contractionary stance of fiscal policy was seen as appropriate in supporting the
contractionary stance of monetary policy to reduce inflationary pressures in 2011. Also the government
argued that the large degree of fiscal stimulus applied to the economy in 2008-09 (to support aggregate
demand and employment) should be gradually withdrawn, as economic recovery was well underway in
2011, with private demand rather than public demand being the main driver of future growth.
In terms of the longer term policy framework (5-10 years), microeconomic policies can be used to help
achieve price stability in the economy. Microeconomic policies are designed to foster structural changes
in product and factor markets that lead to higher levels of productivity, efficiency and competitiveness,
all of which can contribute to greater price stability and lower inflationary expectations.
Microeconomic policies are most effective in containing cost inflationary pressures such as rises in wages
not based on productivity improvements, or rises in the price of raw materials and other productive
inputs due to a lack of competition and efficiency in product markets. Examples of microeconomic
policies used to support the objective of price stability in Australia include the following:
• The national competition policy to promote competitive conduct rules in markets;
• Tariff reform to increase competition from imports in domestic markets, leading to lower prices;
• Taxation reform to remove indirect taxes such as sales tax which distorted prices and raised cost
structures for firms;
• The reform of public utilities and trading enterprises to increase their efficiency and lower prices;
• The deregulation of markets to increase levels of competition and lower prices; and
• The introduction of the principle of workplace or productivity bargaining (through enterprise
agreements) in the labour market to contain wage pressures not based on productivity improvements.
In the 2009-10 budget the government introduced specific microeconomic measures to increase the
productive capacity of the Australian economy and the skills and education of the labour force. These
measures targeted supply bottlenecks to ease inflationary pressures in the future when the economy
returned to full employment. Investment of $22b in nation building infrastructure (such as transport,
communications, energy, education and health) was the centrepiece of the 2009-10 budget.
In the labour market, industrial relations policy has been used by successive governments to encourage
the spread of productivity based enterprise or workplace agreements, with less reliance on awards and
adjustments to the National Minimum Wage for wage increases linked to changes in the cost of living.
The principle of enterprise or productivity bargaining was introduced in 1991 and linked wage increases
in enterprise agreements to improvements in productivity at the workplace level.

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In 1996 the Howard government enacted the Workplace Relations Act 1996 which set out new rules
for the adjustment of wages in awards and workplace agreements. Greater reliance on productivity
bargaining (and less on award adjustments) was legislated through the Workplace Relations Amendment
Act (WorkChoices) in 2006 which also allowed for the negotiation of individual Australian Workplace
Agreements (AWAs) but reduced minimum workplace conditions. The Rudd Labor government
strengthened the safety net in the Fair Work Act 2009 by legislating ten minimum National Employment
Standards; created streamlined Modern Awards; annual adjustments to the National Minimum Wage
by Fair Work Australia; and encouragement of collective bargaining through enterprise agreements.

REVIEW QUESTIONS
INFLATIONARY EXPECTATIONS AND
THE EFFECTS OF INFLATION

1. What is meant by inflationary expectations? How can a wage-price spiral emerge in an

economy?

2. Refer to Figure 9.6 and explain how a trade-off may exist between inflation and unemployment
in the short run as shown by the Short Run Phillips’ Curve (SRPC).

3. Refer to Figure 9.7 of the Long Run Phillips Curve (LRPC) and explain how an increase in
inflationary expectations can lead to higher inflation but no change in the unemployment rate in
the long run.

4. Discuss the effects of inflation on consumers, workers, businesses, exporters, savers, investors and
governments.

5. How does inflation affect saving, investment, resource allocation and international
competitiveness in an economy?

6. Why does the government need to target inflation and achieve price stability in the economy?

7. Discuss how a more restrictive stance of monetary policy can be used to control inflation in the
Australian economy.

8. Discuss how a more restrictive stance of fiscal policy can be used to control inflation in the
Australian economy.

9. Discuss the use of more restrictive stances of monetary and fiscal policies to control inflation in
the Australian economy in 2010-11.

10. Explain how microeconomic policies can be used in the long run to assist macroeconomic
policies to control inflation in the Australian economy.

11. Define the following terms and add them to a glossary:

asset price inflation
Consumer Price Index
cost push inflation
demand pull inflation
fiscal policy
full employment
headline inflation
imported inflation
inflation
inflation rate Phillips Curve
inflation target productivity bargaining
inflationary expectations purchasing power
inflationary gap real income
international competitiveness real wage
Long Run Phillips Curve Short Run Phillips Curve
microeconomic policy stagflation
monetary policy tradables inflation
non tradables inflation underlying inflation

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[CHAPTER 9: SHORT ANSWER QUESTIONS

Relative Inflation Rates 2004-05 to 2011-12 (CPI – all Items, annual percentage change)

Year Australia Japan United States OECD Major 7

2004-05 2.4 0.0 3.0 2.3

2005-06 3.2 -0.3 3.8 2.7

2006-07 2.9 0.2 2.6 1.7

2007-08 3.4 0.7 3.7 2.9

2008-09 1.5 0.5 1.4 1.5

2009-10 3.1 -1.2 2.3 1.7

2010-11 3.6 0.1 1.6 1.5

2011-12 2.3 0.1 3.3 2.7

Refer to the table above of data on relative CPI inflation rates between 2004-05 and
2011-12 for selected countries and answer the questions below. Marks

1. Define the term ‘inflation’. (1)

2. Outline ONE negative effect of inflation on an economy. (1)

3. Distinguish between headline (CPI) and underlying inflation. (2)

4. Contrast the trend in CPI inflation in Australia with the OECD Major 7 (USA, Japan,
Germany, France, UK, Italy and Canada) average between 2009-10 and 2011-12. (2)

5. Explain TWO causes of demand pull inflation and cost push inflation. (4)

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[CHAPTER FOCUS ON INFLATION

Australian Inflation and Real GDP Growth 1980 to 2003

Period Annual Average Variability Real GDP Variability

Inflation in Inflation growth in real GDP

1980 to 1992 7.2% 2.4% 2.8% 2.7%

1993 to 2003 2.3% 0.6% 3.9% 1.1%

Source: Reserve Bank of Australia (2003), Bulletin, April.

“Inflation targeting in Australia has coincided with a period of low and stable inflation, and a
prolonged economic cycle with a high average rate of growth, which has only recently come to an
end because of the Global Financial Crisis. Monetary policy alone clearly cannot take the credit
for these outcomes, but one can argue it has been supportive of them. Monetary policy appears
to have been broadly successful in its aim to ‘let the economy grow as fast as possible, consistent
with the inflation target’.

Source: Reserve Bank (2009), Guy Debelle, Assistant Governor, Speech on “The Australian
Experience with Inflation Targeting”, May 15th.

Explain the use of inflation targeting by the Reserve Bank in conducting monetary policy and
evaluate its impact on Australia’s economic performance.

[CHAPTER 9: EXTENDED RESPONSE QUESTION

Explain the main causes and effects of inflation and discuss the policies that can be used by the
Australian government to control inflation in the economy.

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224 Chapter 9: Inflation © Tim Riley Publications Pty Ltd

CHAPTER SUMMARY
INFLATION
1. Inflation refers to a sustained rise in the price level over time. Inflation results in a reduction in
the purchasing power of money and can reduce living standards and distort resource allocation.
Therefore the government uses its economic policies to try and achieve the goal of price stability.

2. The inflation rate is calculated by measuring the percentage change in prices over time. In Australia
the Consumer Price Index (CPI) is used to measure quarterly and annual changes in the prices of a
selected regimen of goods and services purchased by Australian households.

3. Australia has moved from being a high inflation country in the 1970s and 1980s to achieving
inflation rates consistent with the OECD average in the 1990s and 2000s. This is mainly a result
of the Reserve Bank using monetary policy successfully to achieve an inflation target of 2% to 3%
CPI inflation over the economic cycle. Other policies such as microeconomic reform measures
(including labour market reforms) as well as the impact of globalisation and technological change
in reducing prices have also assisted in the achievement of improved inflation outcomes in Australia.

4. In 2007-08 CPI inflation increased to 4.5% and underlying inflation to 4.3%, mainly because of
strong growth in domestic demand, wage pressures and rising oil and food prices. Higher interest
rates were used by the Reserve Bank to curb this rise in inflation. The Global Financial Crisis and
recession in 2008-09 led to lower CPI and underlying inflation. However in 2010-11 CPI inflation
rose due to the impact of natural disasters on food prices and a range of other domestic price rises.

5. The two main causes of inflation are demand and cost pressures in the economy. Demand pull
inflation occurs when there is an excess level of aggregate demand in the economy which leads
to an inflationary gap. Cost push inflation occurs when the costs of production rise and push up
prices. This occurs as producers pass on cost increases to consumers in the form of higher prices.

6. The level of inflationary expectations is also an important influence on future inflation. A rise in
the inflationary expectations of wage earners and price setters can lead to further wage and price
increases, which may develop into a wage-price spiral and higher inflation in an economy.

7. The short run Phillips’ curve shows the relationship between the inflation rate and the unemployment
rate in the short run. There is a trade-off between inflation and unemployment in the short run,
with higher inflation associated with lower levels of unemployment, and higher unemployment
associated with lower levels of inflation.

8. In the long run, the Phillips’ curve is vertical since there is no trade off between inflation and
unemployment, as there is a natural rate of unemployment in the economy. Therefore attempts by
the government to reduce unemployment will lead to higher inflation and no change in the level of
unemployment. When inflation is not accelerating, the level of unemployment that remains in the
economy is called the Non Accelerating Inflation Rate of Unemployment (NAIRU) which is due to
frictional and structural factors in the labour market.

9. There are a number of negative effects of inflation on an economy:

• Consumers suffer a loss of purchasing power, a fall in real incomes and living standards;
• Saving and investment decisions become distorted because of changes in real returns;
• Exporters and import competitors suffer a loss of international competitiveness;
• There is a reduction in allocative efficiency, as resources are diverted away from productive
economic activities to speculative activities; and
• Governments are faced with increased expenditure in meeting the rising cost of providing
collective goods and services to the community.

Year 12 Economics 2013 © Tim Riley Publications Pty Ltd