Introduction to Macroeconomic

Inflation Target:

Inflation can be defined as the persistent rise in the price of goods and services in an economy for a prolonged period of time, there are two types of inflation namely demand pull and cost push inflation as stated by Keynes. Very high inflation levels in an economy will lead to to a recession in an economy, a recession is characterized by very high inflation levels and at the same time low levels of employment and low income levels.

Monetary policy makers have a role to play in maintaining low inflation levels and high employment levels in the economy. this is ensured through the use of monetary policies such as money supply, interest rates and the use of fiscal policies to avoid inflation which lead to recession. This paper discusses the inflation levels in Australia over the past years and the causes of inflation over the years.

Question 1

Introduction to Macroeconomic

From the mid 1950s up to the mid 1960s there was positive inflation in Australia. Late 1960s up to the 1970s saw an increase in inflation rate, which reached its peak at 17½ percent in 1973 due to the oil crisis (


). The inflation rate from the 1950s up to the year 2002 is as follows.


After the 1982-83 recession it reduced to around 5% but the currency depreciation in 1985-86 led to its increase ( ). On October 20th 1987, the stock market crashed causing a $55 million value at the market capitalization to be lost (

). The monetary policy was eased while liquidity was loosened and from then on the interest rates increased and by 1959 were up to about 18% while the business overdraft rates were over 21% by early 1990. This led to a recession in the 1990-1991 period, which caused the loss of over 300,000 jobs, and this went on for the next 4½ years. When the inflation came down, there was need to keep it that way and thus the adoption of the inflation target in 1993.

The reason for the adoption of inflation target in Australia was as a result of the recession of the period 1990-1991 where unemployment rate increased and inflation was high in the economy, therefore they adopted the inflation target which can be defined as the guide to monetary policies in which it involves estimating a range within which the prices will increase over a period ( ), in 1992 the inflation rate was 2% which is calculated using the consumer price index, there was a need to keep the inflation rate to this level and today the inflation target in Australia rages between 2-3% per annum.

Introduction to Macroeconomic

The aggregate demand and supply model:

Interpretation of the diagram:

The policy makers will always aim at achieving full employment, at the same time the policy makers will always want to keep inflation down, one of the causes of inflation is increased money supply and government spending if an economy does not use a mix policy.

Agree stands for aggregate demand, aggregate demand stands for

Aggre = C + I + G,

Where Aggre is aggregate demand, I is investment, C is consumption, G is government.

The point at which the economy is at equilibrium is Y0 which is the income level, if the level of full employment is at point Y2 then the government will increase spending and this will shift the aggregate demand curve from Aggre 0 to Aggre 1, then the new equilibrium will be at point Y2 which is the intended full employment level and improve the deflationary gap.

If the economy is at point Y0 and the level of full employment is at point Y1 then the government will reduce government spending which will shift the aggregate demand curve from Aggre 0 to Aggre 2, as a result of this the income level shifts from Y0 to the desired full employment level

Introduction to Macroeconomic

Y1, this will also improve the inflationary gap shown above.

Therefore an economy will introduce an inflation target in order to plan for inflation, desired full employment level and government spending, when the level of employment is less than full employment in an economy than the government will increase spending in order to improve this inflationary gap, if the employment level is greater than full employment then the government will reduce spending in order to improve the deflationary gap.

When the government increases spending then there is a high possibility that the economy will experience high inflation, however policy maker will aim at achieving full employment level in the economy through an increase in government spending, through this increase in government spending the policy makers must maintain an inflation target strategy to determine the level of inflation expected as government spending increases.

What would have happened after the early 1990s recession if there had been an expansion in aggregate demand?

Introduction to Macroeconomic

(i) Without an inflation target

If after the recession of 1990 there was an increase in aggregate demand without inflation target then there is a high possibility that the economy will not achieve full employment levels and this would result into inflation that may result into another recession or even the worst which is a depression. The diagram below shows the aggregate demand and aggregate demand curve.

From the above diagram the aggregate demand increases from aggregate demand 1 to aggregate demand 2, if the full employment level is at YF either less or greater than the present achieved output level Y1 then the economy for one will experience high inflation and will not achieve full employment as in the case where there was an inflation target.

(ii) With an inflation target

If there exist an inflation target then the economy would recover from the recession and the full employment level would be achieved with low inflation experienced through achievement of full employment. The diagram below shows policies under an economy that practices inflation targets.

The policy makers will have an inflation target whereby they will use interest rates to solve the problem of inflation and at the same time achieve full employment in the economy, when the aggregate demand increases from aggregate demand 1 to aggregate demand 2, the governemtns target of inflation is at Pt, the monetary policy makers will increase the interest rates in order to shift aggregate demand downwards, as a result of this increase in interest rates the aggregate demand shifts from aggregate demand 2 to aggregate demand 3 and the economies new equilibrium will achieve full employment and at the same time the inflation level

Introduction to Macroeconomic

will be at the targeted inflation level at point Pt.

Question two

Cost-push inflation is caused by the supply side. It is when output is decreasing while prices are rising, the following diagram shows the result of a shock that emanates from the supply side and its effects on output or income.

When cost push inflation occurs then the aggregate supply curve shifts from aggregate supply curve 0 to aggregate supply 1, the income or output level shifts from y0 to y1, price rises from p0 to p1. This form of inflation is very hard to control with monetary policy. When operating at full capacity or near it an increase in the aggregate demand leads to an increase in price with little increase in output. In the long run, the aggregate supply is vertical thus neither monetary nor fiscal policy has any effect. This is because the “multiplier effect of a change in government spending or taxes on aggregate output is zero” ( )

For the economy to counter the loss of output, it has to provide incentives to the producers so that they can produce more. The only way this can be done is by increasing price levels at a rate that cannot be controlled by any policy action. This then makes it very hard to control this form of inflation because of the economy to grow there has to be production to avoid recession. The lack of a policy to govern the economy especially an inflation target means that the expectations of the consumers and producers are high. The firms increase their prices leading to a demand of increase in salaries by the consumers thus causing increase in prices again to ensure the producers maintain their return rates. This shows that it is very hard for the inflation emanating

form the supply side to be controlled by any policy.

Introduction to Macroeconomic


Introduction to Macroeconomic

Aggregate Demand, Aggregate Supply and Inflation 2007. Retrieved on 13th Sept. available at,8233,2032169-00.htm

Case K and Fair R (2002) Principles of Economics, Prentice Hall Publishing, Retrieved on 13th Sept, available at


Costello P. MTIA National Conference Dinner. The Great Hall Parliament House Mon. 20 Oct 1997. Retrieved on 13th Sept 2007 from

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Stevens G.R 2007 Inflation Targeting. A Decade of Australian Experience South Australian

Center                                                                                                                                                                                       for Economic Studies 10th April 2003 Adelaide.

Retrieved on 13


Sept. 2007 from

Introduction to Macroeconomic