Inflation: what is it and how does it affect businesses?

What is inflation and how does it affect businesses?

In 1970, the average Australian full-time wage was about $3,700 per year, the median house price was $17,500, and a copy of the Courier-Mail cost the princely sum of 5c. In 2015, the average full-time wage was $75,000 per year, the median house price was $660,000, and the Courier-Mail would set you back $1.50.

This increase in prices over time is called inflation. It is a powerful economic force, and if not controlled can have a significant impact on a country’s economic fortunes. Its importance is reflected in the fact that one of the RBA’s key mandates in setting monetary policy is control of inflation. Their target is to maintain inflation within the band of 2-3% on average over an economic cycle.

Why does inflation occur?

In simple terms, there are two main causes of inflation. These are commonly known as demand-pull inflation and cost-push inflation.

Demand-pull inflation arises when demand for certain goods or services increases relative to its supply. When this occurs, businesses who supply those goods or services will often elect to increase their prices, and those who want to purchase will often be prepared to pay more.

The primary mechanism through which most central banks manage demand-pull inflation is by reducing or increasing interest rates. Interest rates are considered to be an effective inflation management tool because people are generally willing to spend more money in a lower interest rate environment compared to a higher-rate environment. This increase propensity to spend fuels demand for goods and services and contributes to demand-pull inflation.

Quantitative easing (“printing money”), where additional funds are released into the economy without a change in productive capacity, can also create demand-pull inflation.

Cost-push inflation arises when the cost to produce certain goods or services increases, causing the affected businesses to seek to increase the prices of their goods or services.

One of the primary contributors to cost-push inflation in Australia is wage inflation, due to the strength of the trade union movement. Wages usually comprise a significant portion of the overall cost of manufacturing a good or rendering a service, so a broad-based increase in wage levels will generally necessitate an increase in prices for the business to maintain its profitability.

Cost-push inflation can also be the result of a natural disaster. For example, when Cyclone Larry hit the Queensland coast in March 2006, it wiped out over 80% of Australia’s banana crop. As a result, prices across Australia increased by up to 500% in the ensuing months.

Is inflation good or bad?

Most economists consider controlled inflation to be beneficial, mainly because it encourages people to recycle money through the economy in the form of investment, borrowing and consumption, rather than save it. This ensures that demand for goods and services remains healthy, businesses maintain and increase their inventories, more workers are hired, dwellings and associated infrastructure are built, and confidence is maintained.

To illustrate inflation’s effect on investment and borrowing, consider the simple example of purchasing a residential property. Let’s say I buy a house today for $500,000, using $100,000 of my own money combined with a loan of $400,000. We know from many analyses of historical prices including this one that inflation is a reliable long-term contributor to house price growth. This means that if inflation is maintained within the RBA’s target band of 2-3%, then my house should at least grow in value by that amount each year on average.

Assuming an average inflation rate of 2.5% and no other factors affecting the value, after 10 years my $500,000 house will have a nominal value of about $640,000. Conversely, the associated debt is never adjusted to account for inflation. So even if I make no principal repayments on my loan, and the value of my house only increases at the rate of inflation, the nominal value of the debt over time will remain at $400,000.

Inflation also has a positive effect on consumption because consumers expect prices to continue to rise over time. In a deflationary environment, consumers will tend to hold off on making purchases until the last possible moment, as their expectation is be that prices will fall over time. Controlled inflation ensures that consumption decisions are not postponed because of future price expectations.

How does it affect business owners?

Firstly, businesses should ensure they are regularly increasing their prices to offset the effects of inflation. I know many business owners who don’t undertake this critical activity, either because they forget or because they are worried about an imagined backlash from customers. In doing so they cost themselves tens of thousands or even hundreds of thousands of dollars in revenue over a few years. In contrast, those who implement regular, fair price increases, communicated clearly in advance of their effective date, will maintain their profitability without deterioration in customer relationships.

Secondly, business owners should make a point of offering their staff a salary increase roughly commensurate with inflation each year. In real terms this gesture costs your business nothing; in fact, if you don’t give them a salary increase you are effectively allowing inflation to take money out of their pocket, which over time may erode your employees’ job satisfaction. In contrast, research indicates that offering a small increase – even just to keep up with inflation – will generally have a positive effect on your relationship with your staff. Many economists cite this as another key benefit of controlled inflation.

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