November 2002 When average prices throughout the economy go up, that's inflation.

The fundamental cause of ongoing inflation is too much money chasing too few goods. Inflation usually happens when the economy is so buoyant that shortages of labour and materials become widespread, and prices in general rise. Then money starts losing its value. Typically, an inflation-linked economic boom is followed by a bust. If prices rise faster than incomes, then people are worse off. As well, if the interest paid on savings is less than inflation, then the interest earned does not compensate people for the fact that the value of their savings is being eaten away. Inflation also does long-term damage to the economy. When money is losing its value, businesses and investors have more difficulty making contracts, especially where contracts have to last over time, eg employment contracts and borrowing. This discourages long-term, quality investment in the nation's productive capacity.

Inflation was high during the 1970s and the 1980s, peaking at 18.4 per cent per annum in 1980. In response, in 1989, by statute, the Government gave the Reserve Bank responsibility for keeping inflation low and stable. The specifics of price stability are set out in an additional written contract between the Bank and the Government, called the Policy Targets Agreement (PTA), which is currently set at inflation between 1 and 3 per cent on average over the medium term. Since 1991, inflation has been low and stable, as illustrated. Expectations can affect inflation, at least in the short term. If producers expect inflation (and therefore production costs) to increase, they will include that when setting the prices of their goods. Similarly, if wage earners think that inflation will rise, they may push for higher wage settlements as compensation. With inflation having been low for over a decade, people are now more likely to assume that inflation will stay low when making pricing or purchasing decisions. The flip side of inflation is deflation, when average prices are falling. Deflation can harm the economy too, as it can induce its own distortions, such as people putting off spending because they expect prices to fall. If deflation continues, it can cause a rapid economic slow-down. The Reserve Bank takes keeping inflation above 1 per cent just as seriously as it does keeping it below 3 per cent.

November 2002 The Reserve Bank of New Zealand Act 1989 specifies that the primary function of the Reserve Bank shall be to deliver "stability in the general level of prices." Section 9 of the Act then says that the Minister of Finance and the Governor of the Reserve Bank shall together have a separate agreement setting out specific targets for achieving and maintaining price stability. This is known as the Policy Targets Agreement (PTA). A new PTA must be negotiated every time a Governor is appointed or re-appointed, but it does not have to be renegotiated when a new Minister of Finance is appointed. The Act requires that the PTA sets out specific price stability targets and that the agreement, or any changes to it, must be made public. The PTA can only be changed by agreement between the Governor and the Minister of Finance (section 9(4)). Thus, neither side can impose unilateral changes. Note, however, that under the Reserve Bank Act the Government has the power (section 12) to override the PTA. It can do this by directing the Reserve Bank to use monetary policy for a different economic objective altogether for a 12 month period, though again it must make the instruction public. A new PTA must then be negotiated to cover the override period and another PTA must be negotiated when the override ends. In either case, if a new PTA cannot be negotiated, the Governor can be dismissed. So far, this override section has not been used. There have been seven PTAs so far since the passage of the 1989 Act. Dr Alan Bollard and Finance Minister Michael Cullen signed the current PTA on 17 September 2002. Dr Bollard took up his role as Governor on 23 September 2002. The PTA has four sections. The first confirms that "the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level in prices." It also summarises the Government's overall economic objectives. The second section says that the Bank's inflation target shall be 1 to 3 per cent on average over the medium term, defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand. Section 3 says that when external events push inflation above or below its medium-term trend, "the Bank will respond consistent with meeting its medium-term target." This means that in that circumstance the Reserve Bank is required to get inflation back to "1 to 3 per cent on average over the medium term." The final section describes how the Reserve Bank shall implement and be accountable for its decisions. This includes providing explanations for any inflation breaches, or projected breaches, in the Bank's quarterly Monetary Policy Statements. The last section also says that, as it implements monetary policy to achieve price stability, the Bank "shall seek to avoid unnecessary instability in output, interest rates and the exchange rate." Perhaps the most important feature of the PTA is that it is a public document. As a result, any attempt by a Government to use monetary policy to create a temporary surge in economic activity for electoral advantage would probably fail. This is because a

public announcement that inflation was going to be higher would immediately trigger higher interest rates, offsetting the temporary stimulatory effect of any induced inflation. Prior to the 1989 Act, a government could secretly direct that monetary policy follow a particular path. By contrast, price stability, as required by the Act and the PTA, protects the value of people's incomes and savings. Monetary policy, in itself, can't generate faster sustainable economic growth, but, by delivering price stability, it helps set a predictable background against which businesses and households can make the most effective decisions and by that contribute to maximising sustainable economic growth for New Zealand. As well, monetary policy aimed at price stability helps reduce boom-bust business cycles. This means when the economy falters, inflationary pressures fall and monetary conditions can be eased, which encourages the economy and employment to grow again. The full text of the current and earlier PTAs can be viewed on the Reserve Bank's website.

Demand Factors affecting Australias Rate of Inflation

Any increase in aggregate demand will place pressure on the productive capacity of the economy, and as a result demand side inflation may occur. As such we can predict the possible occurrence of demand inflation by using the model of the market mechanism.

Here we can see that any factor which will cause an increase in aggregate demand may lead to inflation in the Australian economy. An example will make this clear. We will consider the demand side impact of changes in wages on the rate of inflation. In theory, when wages increase the consequences may be an increase in consumption spending. This is because consumers (who receive the wages) will probably choose to spend some or all of the increase in disposable income that they receive. In so doing they will add to aggregate demand.

In the graph above we can see that there is some correlation between changes in wages and the rate of inflation. As the increase in wage rates has grown, the inflation rate has followed a similar trend. Similarly, when the increase in wages was smaller, the demand side pressure on prices was smaller. Therefore the inflation rate was able to trend down. For example, between 1995/6 and 1997/8 the percentage increase in wages fell. At the same time the inflation rate also fell from a peak of 4.2% to 0% in 1997/8. As the increase in wages grew again in subsequent years, the rate of inflation also grew. This is most apparent in 2000/2001. At this time, the increase in disposable income was due primarily to a fall in personal income tax rates. As such, the supply side pressure of increasing wages was not as prevalent. This large increase in disposable income (9.9%) corresponded with the highest rate of inflation for the period 6%.

Demand Factors affecting NZs Rate of Inflation (2)

Of course there are many other demand side factors which can have an impact on the rate of inflation in NZ. Some of these are considered in the table below: Demand Factor Interest rates Theoretical Link to Inflation When interest rates are increased the discretionary income of consumers and businesses will decrease. As a result, we may see decreased spending on consumption items (C) and business investment (I), and hopefully reduced pressure on the rate of inflation. Monetary policy is the major weapon used to fight inflation, and so it is believed that changes in the cash rate can have a very significant impact on this goal. As business managers become more confident they will also be more willing to invest in the future. This may mean an increase in investment spending (I) and hence an increase in aggregate demand. Evidence In 1995 the official cash rate peaked at 7.50% - the highest for the period. This was in direct response to an inflation rate of 4.2% achieved in the same year. After the impact lag associated with monetary policy, the inflation rate fell to 1.3% the following year (and 0.0% the year after). On the other hand the fall in rates after the recession contributed to the fact that inflation was able to move outside of the goal range during 1994/5. According to the NAB Index, business confidence peaked at 21.2 in 1994/5. This corresponded with an increase in private business investment of 11% (the second highest for the period), and direct pressure on prices. At this time, the inflation rate increased from 1.8% to 3.2%. (Note: The second lowest rate of business confidence for the period corresponded to the highest rate of inflation 2000/2001. In this case the pressure on inflation was predominantly due to supply side conditions.)

Business Confidence

Consumer Confidence

When consumers are more confident they are more likely to spend (C), and this can place pressure on the productive capacity of the economy. This demand side factor may lead to an increase in prices

Consumer confidence reached 109 on the Westpac Index during 2001/2002. This was a significant increase on the previous year (101). As a result, the RBA responded with an increase in interest rates even though the inflation rate at the time was within the goal range. Similarly, when consumer confidence reached 109 in 1993/4 consumption spending increased, and the inflation rate in the following year increased from 1.8% to 3.2%. During 2000/2001 out Trade Weighted Index fell from 53.3 the previous year to 49.7. This resulted in an increase in demand for our exports, and corresponded with the highest rate of inflation for the period (6%). (The increase in exports in that year was 7.3% - the following year the TWI appreciated, and exports fell by 1.5%.)

The value of the Australian dollar Changes in the value of the AUD will affect the willingness of people and businesses overseas to purchase our exports. If the AUD depreciates, this will lead to our products appearing relatively cheaper on the international market, and therefore our exports will increase. This equates to an increase in aggregate demand, and this in turn may place pressure on domestic prices (particularly amongst export orientated businesses). Income Tax Rates If income tax rates fall, consumers will have a higher disposable income. Even though their actual pay has not changed, they will have more money to take home. This will lead to higher levels of consumption spending (C) and therefore higher levels of aggregate demand. Once again, this may put pressure on prices in the domestic economy. The government sector is a vital part of the aggregate demand formula. By choosing to increase their spending, the government is directly adding to the level of aggregate demand in the Australian economy. If the government chooses to spend on goods and services already in high

Private consumption expenditure increased by 3.0% in 2000/2001, despite the introduction of the GST. This is due in part to a cut in the rate of personal income tax, which contributed to the rate of inflation seen at that time (a peak of 6%).

Government Spending

During the period 1993-1996 the Keating government ran consecutive budget deficits. This placed considerable pressure on the productive capacity of some sectors, and as a result inflation was allowed to increase outside the goal range during this period peaking at 4.2% in 1995/6.

demand (eg construction labour) there may be some flow on effects to the general price level in the Australian economy. Overseas Economic Conditions If our major trading partners are experiencing strong economic conditions, then it is likely that they will demand more of our exports. The increase in demand for these goods and service will lead to an increase in aggregate demand, and pressure on the Australian price level. During 2001/2002 the US economy grew only 0.8%. As a result, our exports during this period fell, and pressure on prices from the external sector was not as great. However, as the US economy moves out of this phase and returns to strong growth, the RBA has interpreted this as a possible demand side influence on future prices, and interest rates were increased twice at the end of 2003 to combat this at a domestic level.

Supply Factors affecting Australias Rate of Inflation

Any factor that causes a decrease in aggregate supply may lead to inflationary pressures in the Australian economy. As such, we can once again use a supply and demand graph to analyse the way in which a change in these factors may affect the rate of inflation.

From this we can see that as aggregate supply shifts to the left (a decrease) the impact is an increase in the general price level. We refer to this type of inflation as cost inflation. For example, one of the most significant considerations for any business is the price that they must pay for the goods and services that they use in the production of their own final product. We refer to this as the cost of raw materials. When the price paid for raw materials increases, this will have a direct impact on the rate of inflation in Australia. This is because, in very simple terms, businesses prefer to maintain or increase their profits. To do so in a time of rising costs means that they must pass on any increases in costs that they are forced to endure. From a theoretical standpoint, we can say that the increase in costs will mean that suppliers are willing to allocate fewer resources to the production of that item, and therefore supply will decrease. If this is a common trend across the economy, then the impact on aggregate supply may be as seen in the chart above.

A strong link between the cost of inputs and the rate of inflation can be seen in the graph above. The highest rate of increase for the period was 14.4% in 2000/2001. This corresponded with the highest rate of inflation for the period 6% in the same year. (It is very important to note that under the terms of the new tax system, businesses are able to claim back the GST that they pay on inputs. The only person who should incur the GST is the final user of a good or service. However, the change in relative prices within the economy at that time certainly had a supply side impact on the overall prices as evidenced in the chart.) Similarly, we can see that when prices fall the supply side pressure on inflation is removed. For example, in 1996/7 the price of inputs actually fell by 3.7%. In the same year, the rate of inflation fell to 1.3% from a high of 4.2% in the previous year.

Supply Factors affecting Australias Rate of Inflation (2)

Supply Factor Interest Rates Theoretical Link to Growth 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. Evidence 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 1999/2000 (up to 6%) contributed to the inflation rate of 6% recorded in the following year. Due to productivity gains, real unit labour costs (RULCs) have not fluctuated widely during the last 10 years. However, the

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.

biggest increase was in 1995/6 (a 1% increase), and this corresponds with an inflation rate of 4.2% (the second highest for the period). Similarly, RULCs fell by 1.4% in 1997/8, the same year as the lowest rate of inflation for the period (0.0%). The TWI reached its lowest points for the period in 1994/5 (48.4) and 2000/01 (49.7). It is not coincidental that these observed events aligned closely with increasing rates of inflation reaching 3.2% in 1994/5 (and continuing to increase the following year) and 6.0% in 2000/01.

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. 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 an decrease in aggregate supply, and subsequently cost inflationary pressures in the economy. Again, the company tax rate represents a significant cost of production. If the tax rate increases then it is likely that these costs will be passed on to consumers in some way aggregate supply will decrease and therefore shift to the left.

Productivity Gains

Multi-factor productivity is the percentage gain in output as measured against all inputs used in the production process. Multifactor productivity fell on only one occasion during the last 10 years 2000/01 saw a decrease of 1.1%. At the same time, the inflation rate peaked at 6.0%.

Company Tax Rates

After reducing the rate of company tax 33% for the 1993/4 fiscal year, the Keating government increased the rate to 36% in 1995/6. This increase in taxes was undoubtedly passed on, as the inflation rate increased in that year to 4.2%.

Policy Options
The major weapon used to fight inflation is monetary policy. As has been highlighted earlier, the RBA believes that an increase in interest rates will lead to a decrease in aggregate demand, and therefore pressure on the rate of inflation in the Australian economy will be reduced. This policy is implemented with the recognition of an 18 month impact lag the RBA attempts to predict the rate of inflation as it will be 18 months into the future, and interest rates are changed based on these predictions. The success of the RBA in fighting inflation in the Australian economy is very strong. During the last 10 years inflation has not been recorded above 6% - and this figure can be attributed to factors which were outside the realm of control of the RBA. Despite this inflation spike, our average rate of inflation for the period HAS been between 2% and 3%. In other words, the Australian economy has achieved its goals in regards to inflation. Fiscal policy is not used to tackle inflation in the Australian economy. It has been previously noted that any spending by the government may place some demand side pressures on the economy, but given the change in the way in which fiscal policy is now used in Australia, this pressure is negligible. On the other hand, microeconomic reforms can have a very strong affect on prices in Australia. In your study of Unit 4, you will discover that changes to the airline industry, the telecommunications sector and the financial sector have all resulted in decreased pressure on prices. The long term impact of these changes is that productive capacity in the Australian economy is improved, and therefore we are more able to cope with increases in aggregate demand.