Question

1. Inflation and the Australian Economy The Australian Bureau of Statistics recently reported that there was no change in consumer prices between the start of January and end of March, equating to a quarterly inflation rate of 0%. The Reserve Bank of Australia has highlighted their concerns that inflation has been consistently lower than their target range of inflation a) Why would the RBA consider inflation that is too low to be problematic for the Australian economy? b) What measure could the RBA implement to bring the inflation rate back to within their target range of 2 to 3%? Using the ADAS model, explain how this measure impacts the economy in the short run, detailing the impact to output, inflation and unemployment c) Using the ADAS model, explain how the economy will adjust in the long run. Compare the new long run equilibrium against (i) the initial long run equilibrium and (ii) the short run equilibrium in terms of output, inflation and unemployment (5 marks)

Answer 1

a. Too low inflation is not good for any economy because of the trade off between inflation and unemployment. At low levels of inflation, the unemployment in the economy is high which leads to low level of output in the short run.

b. To increase inflation, the RBA could use monetary policy to increase money supply. This shifts the money supply curve to the right which decreases interest rate. This leads to an increase in private investment which shifts the AD curve to the right. At this new equilibrium, output level is higher than the original output level and prices are higher than the initial price level. Since there exists an inverse relation between inflation and unemployment, unemployment at this new level of output is lower than the unemployment at the original level of output.  

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The AD curve shifts from the red line to the blue line.

c. Since the RBA intervened and increased the inflation rate to the target inflation rate, the economy will not show any long run adjustments as it is already functioning at the potential output level. In the initial case where the inflation rate was too low and unemployment was too high, this would have led to reduction in wages. It would be cheaper for firms to produce at these new lower wages and hence they would increase their production levels. The AS curve would shift to the right in this case. At this equilibrium level, output is at the potential level for the economy, but the prices fall down even further.

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The AS curve shifts from the green line to the purple line. Output is at the potential output level and prices are even lower than the initial equilibrium level.