Inflation and its solution

Inflation is the inevitable result of economic growth. However, the high inflation will also threaten a country’s economy to grow stably. Australian government and Reserve Bank of Australia’s official target is to keep inflation rates between 2-3 per cent per annum. If the inflation rate above the RBA’s target, it would cause three types of concerns to economy and society, they are output effect, means the output will fall when prices increase; income redistribution and wealth effects, means inflation makes somebody better off and others worse off; and the effects on international competitiveness means a country becomes less competitive in global economy when its exports fall and imports increase during inflation.

RBA can use contractionary monetary policy to decrease the inflation pressure. This can be achieved by combing the open market operation and transmission mechanism. Eventually, the inflation pressure will fall when the aggregate demand and expenditure decreased. Introduction Inflation is an inevitable consequence associated with economic growth; however, it would also threaten a country’s economy to grow if it was too high or above its target. This paper will basically discuss the concerns caused by high inflation, followed by the evaluation of policies can take to adjust this situation.

Body -concerns when inflation is above RBA’s target Figure1 (Bernanke,B.S ; Olekalns, N ; Frank,R.H 2008,P315) Inflation, is the tendency for the overall level of prices in an economy to rise through time (Bernanke,B.S ; Olekalns, N ; Frank,R.H 2008). The graphs above show the process of how the inflation occurs. Australian government and RBA agreed to target inflation rate of 2-3 per cent on average (Day, 2009, p40).

When inflation rate is above RBA’s target, it will cause concern for both the economy and society. The concerns/effects of inflation can be broadly categorized into three areas; they are output effects, income redistribution and wealth effects and effects on international competitiveness.The presence of inflation can have impact on output level is explained by the uncertainty. Continual price raises lead to uncertainty about future and thus make decision-making more difficult for investors because investments seem more risky during high inflation, thus investors may stop investing during inflation for guaranteeing their rate of returns.

In addition, the production costs pushed to increase associated with all prices to increase during inflation. Thus, the final output generated will be decreased with the same amount of input. Consequently, the output must be decreased from the decrease in real output and decrease in investment. Income redistribution and wealth effects The burden of inflation does not fall evenly on all sectors if the community. Some households are worse off. Others, particularly those who are able to anticipate the inflation, may be able to arrange their financial affairs to benefit from expected price increases. The following comparisons give the explanation of how someone worse off when someone else better off.

a. Borrowers VS lenders Borrowers tend to benefit from inflation, because they are able to build up their assets on borrowed money, knowing that the real value of their repayments will fall over time. In other words, borrowers’ purchasing power will increase during inflation. However, lenders must be worse off when borrowers better off during inflation. This means, long term lenders will be repaid in inflated dollars which have reduced lenders’ purchasing power.

b. Tax payers VS government Taxpayers suffer from “bracket creep” as inflation gradually causes their income levels to rise to levels where they are liable for higher marginal rates of taxations. However, government revenue increases as a result of this “bracket creep” (Parry,G & Kemp, S 2005). To sum up, if Australian inflation rate above the RBA’s target, it would cause concerns for both the economy and society.

These concerns categorized into the output effects, income redistribution and wealth effect and the effects on a country’s international competitiveness. In order to eliminate the expansionary gap associated with the inflation, RBA can use the contractionary monetary policy to increase the interest rates, which can be done by combining the open market operation and transmission mechanism. Consequently, the inflation can be effectively controlled accompany with the increase in interest rates.

Bibliography

Bernanke,B.S, Olekalns, N and Frank,R.H (2008) Principles of macroeconomics McGraw Hill Australia Pty Limited

Figure 1- Bernanke,B.S, Olekalns, N and Frank,R.H (2008) P315 Principles of macroeconomics McGraw Hill Australia Pty Limited