Factors Affecting Inflation

Inflation, which refers to the increase in prices of goods and services, is measured in Australia using the Consumer Price Index (CPI). The Reserve Bank of Australia has set a target range of 2 to 3 percent for annual consumer price inflation. Inflation can be driven by three main factors: demand-pull, cost-push, and inflation expectations. The Reserve Bank takes these factors into account when analyzing and predicting inflation trends. Alternative measures of inflation generally exhibit similar long-term patterns.

Demand-pull inflation occurs when aggregate demand surpasses the sustainable supply of goods and services, leading to price increases and inflation. Increased consumer, business, or government spending, as well as growth in net exports, drive the rise in aggregate demand. Firms respond to the increased demand by raising prices and expanding their profit margins. This prompts them to hire more workers and offer higher wages, further stimulating consumer spending and aggregate demand. Conversely, a decrease in aggregate demand results in reduced hiring, lower wages, decreased consumer spending, and a decline in inflation. The economy's potential output represents the sustainable level of production that does not cause inflation, and it is determined by indicators such as GDP and the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Inflation rises when unemployment falls below the NAIRU and decreases when unemployment exceeds it.

Cost-push inflation occurs when the total supply of goods and services in the economy decreases due to an increase in production costs. This can be caused by higher prices of inputs like oil or raw materials. As production costs rise, firms reduce output and raise prices, resulting in inflation. The impact can extend to other goods and services, such as higher transportation costs affecting grocery prices. Supply disruptions, such as natural disasters, can also contribute to cost-push inflation, causing temporary periods of elevated inflation, particularly in industries like agriculture and food processing.

Exchange rate fluctuations influence inflation through imported inflation. When the domestic currency depreciates, the prices of imported goods and materials increase, directly contributing to inflation. Additionally, a weaker currency stimulates aggregate demand by making exports cheaper for foreign buyers, encouraging domestic consumers and firms to shift towards domestically produced goods. This increased aggregate demand puts pressure on domestic production capacity and allows firms to raise prices, indirectly contributing to inflation. The impact of exchange rate movements on inflation is primarily observed in tradable goods and services, while non-tradable goods and services are more influenced by domestic factors.

Inflation expectations, which represent the beliefs held by households and firms regarding future price increases, significantly influence actual inflation rates. When expectations are anchored to the central bank's inflation target, temporary periods of higher inflation are unlikely to cause lasting changes in behavior, and inflation is expected to return to the target range. However, if expectations become unanchored, persistently higher inflation can occur as households and firms adjust their behavior based on anticipated future inflation. Anchored expectations make it easier for central banks to manage inflation. Measuring inflation expectations is challenging as they are not directly observable, but they can be assessed through surveys or by examining financial assets like government bonds, which reflect assumptions about future inflation.

Source: https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html