Economic Policy Objectives
What is it?
Price stability ensures there is a gradual and sustainable rise in the general price level of goods and services. Gradual rises in inflation ensures confidence and competitiveness in the economy.
Why is it Important?
The Costs of HyperInflation (Very High Inflation)
If prices become out of control and rise too quickly then real purchasing power could decrease. The Government needs to ensure that wages are growing faster than inflation to ensure that Australians maintain or expand their purchasing power.
Think about it like this. Say there is only one good in the economy - bananas, and they're priced at $2. You earn $10 from your job as a banana worker, so you can buy 5 bananas with your income. If prices of bananas rise from $2 to $4 (inflation) but your wages stay the same at $10, you can only buy 2.5 bananas, hence you are worse off. Your material standard of living has decreased as you cannot consume the same amount of goods and services.
Hyperinflation also positions an economy's goods and services as internationally uncompetitive. If prices of a country's exports rises too fast and above the rate of inflation of other countries, then its exports will be positioned as uncompetitive. Think about it this way, if Japanese car exports are rising in cost of 4% per year and Australian car exports are rising in cost of 2% per year, the Australian car exports are more competitive as the price of those exports are rising in price that is lower than Japanese cars, hence making China more internationally competitive. If both cars cost $1000 at the start of the year, then at the end of the year the Japanese car would cost $1040 while the Chinese car would cost $1020 on the world market. A more affordable export means a more internationally competitive export.
The Costs of Deflation
If prices deflate, that is prices of goods and services are falling, this could also be bad for the economy. Lower prices means businesses are turning over lower profits, reducing production and increasing unemployment.
In addition, people will choose to hold onto their money as they may expect prices to fall even further. Why bother spending if the value of your goods and services will decrease anyway?
With people holding onto their money, financial institutions could also collapse if they may receive too many deposits but not enough lenders.
What is the Target for Price Stability?
The Reserve Bank of Australia sets the target for inflation as within 2-3% growth per year. The Reserve adjusts its monetary policy mainly on the changing inflationary rate. If the RBA believes the medium term outlook for inflation is below 2%, then it will lower the cash rate to encourage economic activity to increase competition for resources and hence, increasing inflationary rates towards the target band. If the RBA believes the medium term outlook for inflation will rise above 3%, then it will increase the cash rate to decrease economic activity, decreasing competition for resources and hence, lowering inflation towards the target band.