Day 29 Inflation

Inflation

The inflation, a familiar word we heard over and over in the news. Somehow most of us only have a general idea about inflation, which is the increase on price for the goods and services. However, as an important factor in macroeconomics, inflation will indicate much more than the overall price change. 

What is inflation? For simplicity, let us assume we purchased a basket of commodities last year, it consists of all the basic goods and services we need. So the inflation rate is , in this specific case, the proportion of price changed for the same basket this year. In the long-term, the inflation rate for each year tends to be stabilized(without drastic variation), and this is what we called the “inflation inertia”. When an economy’s actual output is larger than its potential output, in norther word, the country’s gross domestic product(GDP) exceeds the predicted GDP using resources at normal rate. This output gap is referred as expansionary gap, people spend more and save less during economic expansion. As a consequence, the demand of goods and services will increase, eventually, the firms will raise the price on their product. That is the major reason that creates inflation, simply because we earn more and want more, so the price has been bid up. Inflation is a never-ending circle due to the public expectation. People are aware of the term, thereby they ask the employer to adjust their wage level corresponding to their expected inflation rate for this year. Responding to that, the employer will increase the price on their products, in order to cover the marginal cost. These price change will integrate to the inflation level, thus the employee’s expected inflation ratio is based on their experience of past years inflation. It is a cyclical effect overall.

A high inflation rate can bring a lot of problems to the economy. For the most straight-forward problem, it decreases the real value of our income. Apparently, with 10 dollars, we cannot purchase the same quantity of porterhouse steak today compared with 10 years ago. Especially with those people have poor economic condition, who used more portions of distributable income on daily expenditure than rich people. However, Australia has adopted the wage index system long time ago, hence people’s nominal wage will be adjusted with the inflation rate. Therefore, the reductions in real income effect were minimized. The true costs of inflation are on other criteria. The most renowned two are the shoe-leather costs and the menu cost. Since the cost of holding money on hand is the opportunity cost of earned interest with that amount, people are less likely to hold a lot of money on hand during high inflation. Because, the real interest rate is high corresponding to the high rate of inflation( I will explain this later), plus the purchasing power of money on hand is diminishing, people will prefer to save money or purchase financial assets. The shoe-leather-cost is a vivid portrait describing the cost occurred for people travel to the bank in order to settle transactions, and their shoe leather’s wear and tear. The menu cost is the cost incurred for restaurant owners to reprint their menus according to the new price.

High inflation can be harmful to an economy, so it is the Reserve Bank’s responsibility to control it. The central bank will monitor the inflation level, and modify it by changing the real interest rate. Put more bluntly, the increase in real interest will reduce the aggregate spending in the economy, because household will save more pursuing the high return. In addition, firms will postpone on investing new capital goods, due to borrowing under high interest rate becomes costly. Since the aggregate expenditure( which is equal to the actual output) declined, the inflation rate will drop as well until the equilibrium output. To be concise, we can state that reduction in demands causes the firm to reduce the price for the purpose to sell more, as a result, the inflation rate is dragged down. If the inflation is too stubborn and refuse to change correspond with normal Reserve Bank’s coordination. The central bank may choose to ‘tighter’ its policy reaction function, which is to adjust the interest rate at a higher level of inflation rate. This is also a part of the conractionary monetary policy that we might have heard of. By the way, the reserve bank controls the interest rate through the overnight cash market rate.

This is a brief introduction to the inflation in an economy, I hope it helped a little for your understanding for this term.