Deflation v disinflation
Why inflation is bad
Goal of low inflation
Why the RBA targets 2-3%
Measurement of inflation
Headline v underlying
why inflation is bad
High inflation has a number of negative effects on the economy and living standards more generally. When inflation is too high (e.g. above 3%) it will make it increasingly difficult to achieve other economic goals (e.g. external stability, economic growth, full employment, and equity in the distribution of income) that are necessary for living standards to be maximised. Accordingly, the government recognises that once Australia achieves low inflation, it has established an economic environment that is conducive to the achievement of all economic goals. For example, a high rate of inflation will reduce Australia's international competitiveness, reducing net exports and AD, which then reduces economic growth and tends to increase the rate of unemployment. This ultimately has a negative impact on both material living standards (via relatively less incomes being earned) and non-material living standards (via loss of self-esteem and purpose to the newly unemployed).
More generally, relatively high rates of inflation will tend to have the following negative effects on the economy which all ultimately result in lower rates of economic growth or equity concerns.
- distorts the allocation of resources (e.g. resources re-allocated from productive exploits to non-productive assets that hold their value well and other activities designed to protect against inflation);
- redistribute incomes from those on relatively fixed incomes to those on flexible incomes;
- redistribute incomes from taxpayers to the federal government via the effects of bracket creep or fiscal drag (where nominal wage increases move taxpayers into higher income tax brackets which reduces their real disposable income;
- redistribute incomes from lenders to borrowers when interest rates are slow to adjust;
- reduces 'real wages' of workers (therefore eroding purchasing power of incomes), particularly those workers on lower income/skilled earners, who have little bargaining power to demand higher wages that will prevent any erosion of their purchasing power (and therefore maintain real wages);
- can cause a 'wage/price spiral' where higher nominal wage demands to protect against inflation causes higher costs of production which then creates further pressure for prices to rise;
- cause a loss in international competitiveness and therefore decrease export income as well as the income of import competing producers;
- can cause a loss in consumer and investor confidence as uncertainty about future price movements increases;
- can cause a loss in international investor confidence, causing greater volatility in foreign investment and interest rates;
- increases interest rates and the risk of policy tightening, which then have detrimental effects on economic growth; and
- causes a waste of resources that are used to continually change prices on various goods and services.