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Inflation is the general upward trend in the level of prices. Inflation causes the purchasing power of money to fall. Inflation is categorised in two types being demand-pull inflation and cost-push inflation.
One of the main causes of inflation is excess demand. If demand is growing faster than the level of supply, then prices will increase. Output will increase as well, as there is a shift along the aggregate supply curve, but because supply cannot keep up with demand prices go up as well. Demand-pull inflation will therefore occur in a booming economy. To avoid demand-pull inflation the economy should grow at a steady rate.
Cost-push inflation occurs when production costs increase. To maximise their profit, they need to increase their profit. Therefore cost increases have pushed inflation up. Cost-push inflation occurs because of different factors. Wages are a major part of the production costs and if workers demand a wage rise, firms need to increase prices to prevent form losing from increased production costs and therefore causing inflation. Workers may demand a wage increase because of the expectation theory. (They expect something to happen and act in such a way to cause it to happen.) The value of the Australian dollar compared to other currencies is also an important factor especially if businesses use imports in the production process. If other countries have high inflation or the Australian dollar is weak, it causes imported inflation. Increase in interest rates can cause inflation if businesses borrowed money to aid production process. If the government change or add extra tax a business may experience increased production costs and it will lead to inflation. (Implementing of GST caused inflation as products are now more expensive. Australia's latest rate of inflation is around 2.9%, while the inflation rate was about 6% when GST was introduced.) The effect of cost-push inflation is to shift the aggregate supply curve to the left.
Inflation causes problems for individuals as well as for the whole economy. Some causes are: The redistribution of income – a great amount of people live on fixed income, especially pension owners. The higher the level of inflation the less their income will be worth. This also happen among working people, as inflation increases faster than their income. Businesses and individuals would have to face inconvenient costs such as extra administrative work, redo their supply lists, price lists, business and individual budgets etc. Inflation will cause Australia to be less competitive in the export market. If inflation causes prices to be very high, other countries wouldn't compete with Australia causing our goods to be less in demand. This is very important because the export market is very important to the Australian economy. Inflation causes uncertainty for businesses and individuals. Uncertainty causes slower or negative economic growth because business and consumer confidence decrease. (This was recently seen because of 9/11)
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