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1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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The importance of the underlying rate of inflation

The RBA target for low inflation is clearly quoted in terms of the headline rate of inflation - seeking to achieve a 2-3% rate, on average, over the cycle.  'On average' means that the RBA accepts there will be some short term volatility around the target rate over the cycle. This was highlighted by the RBA Governor at the House of Representatives Standing Committee on Economics in November 2010.

‘The promise that we make actually is not that we will always be between two and three per cent. In fact, half the time we are not; we have been above and we have been below. In practice, you really cannot fine-tune-or at least we have not been able to fine-tune- inflation so closely that you are never outside that band. So it is not a band in that sense; it is a central tendency. Two years ago we were at five per cent which was way too high and we wanted to come down. We set policy to that objective and it has come down. Over the 17 years since we first articulated the target, the average CPI inflation rate in that period is pretty much exactly 2.5 per cent. So we have been as low as one per cent and as high as five per cent. We have been outside the two to three per cent probably almost half the time, but the average-which is what matters most-is bang on 2½. That is what we are seeking to deliver.’

This 2-3% average can only be achieved if the RBA, when deliberating on monetary policy, focuses on a measure of inflation that provides it with an understanding of the core or underlying price pressures existing in the economy.  Accordingly, it uses the 'underlying rate of inflation' as the key statistic that helps it to forecast what is likely to be happening to the headline CPI in the future.  In other words, the underlying rate of inflation remains an important tool used by the RBA even though it is not specifically referred to in the target.  

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