Deflation v disinflation   Why inflation is bad   Goal of low inflation   Why the RBA targets 2-3%   Measurement of inflation    Headline v underlying   Inflationary expectations

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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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Why the RBA targets 2-3%

The Australian Government is keen to avoid the economic costs associated with a high inflation rate, as these costs are ultimately borne by all Australians.  Accordingly, the RBA focuses primarily on the prices faced by consumers of goods and services.  It targets a range for inflation (on average over the economic cycle) because it provides the RBA with the flexibility to shift its focus away from inflation (and allow it to climb towards 3%) in an effort to achieve higher economic and employment growth. This flexibility is required for monetary policy to properly operate within its charter and act as a key stabilisation policy of government. A range for inflation of 2-3% also provides a more realistic target that allows for national variations in the rate of inflation over time.

Why not target an inflation rate of zero?

There are three main factors preventing the RBA targeting an inflation rate of zero.

  1. Small amounts of inflation actually allow for reductions in the ‘real’ prices of some goods and services (particularly labour services) without a reduction the ‘nominal’ price (e.g. the nominal wage).  For example, during a recession it may be necessary for some wages to decrease as demand for labour falls.  However, wages are generally ‘downward rigid’ in nominal terms, thereby causing some unemployment.  If we have some inflation, the real wage can reduce without a reduction in the nominal wage.

  1. Some inflation is really accounted for by rising quality of goods and services, which may not be fully captured in CPI figures.  (Hence, CPI is said to overstate the extent of inflation.)  For example, inflation of 4% for a year is less of a problem if the average quality of goods and services increased by 4% over the period and the ABS was not able to accurately account for these quality improvements in its calculations.

  1. It may create other economic problems like growth rates that are too low, increases in unemployment and/or even deflation, which has a negative impact on growth and employment as consumers delay purchases in anticipation of future price reductions.  

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