The Effects of Inflation and Policies to Sustain Low Inflation (HSC SSCE Economics): Revision Notes

The Effects of Inflation and Policies to Sustain Low Inflation

Introduction

Inflation significantly impacts economic performance in both the short and long term. The higher the inflation rate, the more severe its negative consequences tend to be. This is why governments worldwide prioritise maintaining low inflation rates. Understanding how inflation affects different parts of the economy—and the policy tools available to control it—is essential for analysing macroeconomic stability.

The effects of inflation

Economic growth and uncertainty

Inflation acts as a major constraint on sustainable economic growth. When the economy grows too rapidly, it generates inflationary pressures through increased wage demands and strong consumer demand that pushes up price levels. To prevent runaway inflation, authorities must then slow growth through higher interest rates.

Low inflation creates favourable conditions for steady growth. Australia experienced three decades of sustained low inflation from the early 1990s, which allowed for an extended period of relatively strong economic expansion. During this time, businesses and consumers could make long-term decisions with greater confidence.

Business investment suffers under high inflation because producers face uncertainty about future prices, costs, and therefore profit levels. Without clarity on these fundamentals, businesses become reluctant to commit to long-term investments in productive assets. Instead, they may favour short-term, speculative investments that can be quickly liquidated. Low inflation reverses this problem, encouraging firms to invest in equipment, technology, and facilities that enhance productivity.

Consumer behaviour also changes with inflation levels. Sustained high inflation reduces money's purchasing power and creates cost-of-living pressures. Theoretically, low inflation should encourage higher saving rates as consumers feel more secure. However, Australian experience shows that other factors—such as house prices, superannuation values, and overall economic outlook—often have greater influence on savings behaviour. During periods of strong economic performance and rising asset values, consumption tends to increase and savings rates fall, even when inflation remains low.

Wages

The inflation rate heavily influences nominal wage demands—the dollar amount workers receive before adjusting for price changes.

During periods of higher inflation, workers seek larger wage increases to compensate for the erosion of their wages' purchasing power. This can trigger a wage-price inflationary spiral that becomes difficult to break: wage increases lead to higher production costs, which producers pass on through higher prices, prompting workers to demand even larger wage increases, and so on.

Income distribution

High inflation tends to worsen income inequality because lower-income earners often experience slower income growth than the rate of price increases. Several factors explain this negative impact:

• Lower-income workers typically have less bargaining power to secure wage increases that match inflation
• They may face higher interest rates on existing borrowings when inflation rises
• Fixed-income recipients (such as pensioners without indexed payments) see their real income decline
• Those with savings but no means to protect them from inflation experience wealth erosion

Unemployment

Unemployment and inflation show a complex relationship, particularly demonstrated by the Phillips curve, which illustrates the short-term inverse relationship between these two variables.

In the short to medium term, higher inflation typically results in contractionary fiscal and monetary policies. Authorities raise interest rates to cool demand, which slows economic growth and increases unemployment. Conversely, periods of high unemployment often feature low inflation, whilst low unemployment is frequently associated with rising inflation.

Governments historically faced a trade-off between prioritising low inflation (accepting slower growth and higher unemployment) or lower unemployment (risking higher inflation). However, this inverse relationship doesn't always hold, especially over longer periods.

International competitiveness

High inflation damages export competitiveness because it increases the prices of Australian exports. Foreign buyers find Australian goods and services more expensive, reducing the quantity demanded. Simultaneously, domestic consumers switch to cheaper imported substitutes as local prices rise. This double effect worsens the trade deficit.

Low inflation improves competitive position. Australian goods and services become more attractive to international buyers due to relatively lower prices, potentially expanding export volumes. Domestic consumers also find local products more competitive with imports, which can improve the trade balance through both increased exports and import replacement.

Purchasing power parity and exchange rates

The theory of purchasing power parity explains the long-term link between inflation and exchange rates. This theory states that exchange rates will adjust over time to reflect the real purchasing power of different currencies. Globally traded goods—such as processed food, clothing, and electronics—should cost roughly similar amounts across countries once converted to local currency.

Limitations of the theory: Purchasing power parity doesn't work perfectly in practice due to:

• Transport costs
• Taxes and tariffs
• Short-term financial flows affecting currencies
• Trade barriers

Nevertheless, it serves as a long-term anchor for exchange rates between countries.

Exchange rate impacts

In the short term, higher inflation may actually cause currency appreciation. Speculators anticipate the RBA will raise interest rates to combat inflation, which attracts international financial flows seeking higher returns. This increased demand for Australian dollars drives appreciation.

Over the long term, however, high inflation generally causes currency depreciation. Australian experience provides evidence of this relationship, though it's worth noting that the reverse relationship (depreciation causing inflation) is often stronger.

With sustained low inflation, international confidence in the Australian economy may strengthen, potentially supporting a higher dollar value over extended periods.

Interest rates

Lower inflation typically brings reduced nominal interest rates. This occurs because nominal interest rates consist of a real rate of return plus an inflation component.

The central bank adjusts interest rates to reduce demand pressures in the economy and prevent the negative consequences of high inflation from becoming entrenched.

Benefits of inflation

Whilst inflation's negative effects receive most attention, small amounts of inflation provide some benefits:

Price adjustment flexibility: A modest inflation rate allows relative prices to adjust across the economy without requiring actual price cuts. This is important because prices—especially wages—tend to be "sticky downwards," meaning people resist accepting lower nominal amounts even when economic conditions might justify it.

Central bank targeting reflects these considerations. The RBA and other central banks target low positive inflation (2-3% in Australia's case) rather than zero inflation. This approach avoids inflation's negative consequences whilst maintaining a buffer against deflation and other economic problems.

Policies to sustain low inflation

Since inflation fell sharply during the early 1990s recession, Australian authorities have prioritised maintaining low inflation. Whilst multiple policy tools can address inflation, they play different roles and have varying effectiveness.

Monetary policy

Monetary policy has served as the primary tool for maintaining Australia's low inflation record since the early 1990s. In the short to medium term, it remains the main instrument for reducing inflation.

How monetary policy controls inflation: The Reserve Bank of Australia uses interest rate adjustments to influence aggregate demand in the economy. When inflation starts rising:

1. The RBA tightens monetary policy by raising the cash rate
2. Higher interest rates increase throughout the economy as banks pass on the increase
3. Consumer spending falls as borrowing becomes more expensive and saving more attractive
4. Business investment declines due to higher borrowing costs
5. Lower aggregate demand reduces pressure on prices
6. Inflation moderates

Pre-emptive monetary policy

The RBA generally implements pre-emptive monetary policy, meaning it adjusts interest rates to prevent inflation from emerging as a problem rather than waiting until inflation has already risen significantly. This forward-looking approach has several advantages:

• Inflation expectations remain anchored at low levels
• Smaller interest rate changes are needed
• Economic disruption is minimised
• Credibility is maintained

Anchoring expectations

The RBA has made its monetary policy approach predictable by consistently emphasising its intention to use interest rates primarily to keep inflation within the target band. This clear communication has helped lower inflationary expectations throughout the economy.

When businesses and workers expect low inflation to continue, they moderate their price and wage demands accordingly. This makes the RBA's job easier, as inflation remains subdued even when the economy grows strongly.

Fiscal policy

Fiscal policy plays a supporting role in maintaining low inflation. During periods of rising inflationary pressure, the government can use fiscal policy to reduce aggregate demand:

• Increasing revenue through higher taxes or broader tax bases reduces disposable income and therefore spending
• Reducing government spending directly lowers aggregate demand
• The combination creates a contractionary effect that moderates demand-pull inflation

Recent experience shows limited use: With inflation remaining low in recent years (until 2022), fiscal policy hasn't needed to focus on restraining inflationary pressures. Instead, other objectives—such as supporting growth during the pandemic—took priority.

Microeconomic policies

Australia's microeconomic reforms have contributed significantly to the long-term low inflation record through several channels:

Competition policy

Reduced tariff protection has:

• Lowered import prices, directly reducing consumer price inflation
• Increased competition faced by domestic producers from overseas competitors
• Encouraged new entrants to domestic markets
• Made it harder for domestic producers to raise prices without losing market share

This heightened competitive environment naturally restrains price increases without requiring direct policy intervention.

Labour market reforms

Labour market reforms aim to link wage increases with productivity improvements. If productivity rises—meaning workers produce more output per hour worked—the economy can afford real wage increases without generating inflationary pressures. Both firms and workers benefit: firms maintain profitability whilst workers enjoy higher living standards.

Infrastructure investment

Greater investment in economic infrastructure helps avoid bottlenecks that can increase production costs:

• Improved roads, railways, and ports reduce transport costs and delays
• Better freight networks allow goods to move efficiently between production and consumption points
• Reduced congestion and capacity constraints prevent supply-side cost pressures

By addressing physical constraints in the economy, infrastructure investment helps maintain low inflation even during periods of strong growth.

Long-term outlook

The combination of policy tools has proven effective. The RBA's commitment to the inflation target, combined with heightened competition and flexible markets, makes a return to the high inflation of the 1970s and 1980s unlikely.