Why did the RBA choose an inflation target of 2-3%?

This article explains why the Reserve Bank of Australia (RBA) chose to set an inflation target of 2-3% on average over the long-term. It discusses the benefits and disadvantages of this target and its impact on the economy.

Running head: ECONOMICS
Economics
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ECONOMICS
Why did the RBA in 1991 choose to set an inflation target of 2-3% on average over the
long-term?
Inflation is known as the quantitative measure of that particular rate at which the
average price level of a basket of selected commodities or services of an economy rises over
the period of time. The inflation targeting is the policy of the central bank of any country that
usually revolves around meeting preset and publicly displayed targets for the annual inflation
rate. The benchmark that is generally used for targeting inflation is the price index that is
used for a basket of consumer goods which is also termed as the consumer price index.
The inflation target is stated to be the medium term average which is held at all times.
The Reserve Bank of Australia is known to formulate as well as implement the monetary
policies. The monetary policies is known to set the interest rate on overnight loans in the
money market. The Reserve Bank Board will be setting the rate of interest in order to
achieve the following objectives which are the stability of the currency of Australia,
maintaining full employment. It also makes sure that it maintains economic prosperity of the
Australian people. From the beginning of 1990, in order to achieve these objectives, the
government of Australia have targeted the inflation rate to 2 – 3 percent. The Governor of
Australia have agreed had agreed that the appropriate target of the monetary policy in
Australia is to maintain the inflation target at 2-3 percent. The reason is that this particular
rate of inflation is known to be quite low so that it does not hampers the decisions of the
economy in the community. In order to achieve this particular rate of inflation, the
government needs to revise its monetary policy that serves as an anchor for the inflation
expectations of the private sectors.

ECONOMICS
The inflation target allows for inevitable uncertainties which are known to involve in
forecasting. It is also known to lag in the effects of the monetary policy in the economy.
However, in some of the cases it has been quite difficult for keeping the rate of inflation at 2
to 3 percent. The inflation target in case of Australia is also forward looking in nature. This
particular approach will allow a role for the monetary policies in dampening the output
fluctuations that takes place over the business cycle. In some cases when the demand of
goods or services in the economy will be weak in nature, the inflation will be diminishing in
nature and at that time the monetary policy can be eased that will help in stimulating various
economic activities.
Disadvantages of deflation
Inflation can be harmful sometimes, however deflation is more harmful in nature. For
this reason, the government does not aim to target inflation at zero percent. The government
always tends to aim for inflation of 2 percent since this will enable price and wages for
adjusting without causing any kind of uncertainty of high rate of inflation. Low inflation rate
is also linked to the goal of the stable growth in the economy. However, there are various
disadvantages in case of deflation or zero inflation in the economy.
Deflation can lead to rise in the real value of the debt. When there is 0% inflation in
the economy, it becomes tough for the people to pay back their debts since they need to spend
higher amount of incomes on debt repayments.
Deflation in the economy will also delay purchasing. Falling prices will make people
delay to buy expensive luxurious goods as they feel that the prices will be declining more in
the next year.

ECONOMICS
Zero percent inflation will also make it harder for the prices and wages to adjust in the
economy. When the rate of inflation is generally two to three percent in the economy , it
becomes much easier for the prices and wages to adjust since firms will be able to freeze
prices and wages and use the prices effectively. On the other hand, when the inflation is zero,
the firm at that point of time will need to cut the nominal wages by two percent. In some
cases when firms will not be able to adjust the wages, it might lead to real wage
unemployment in the economy.
Zero inflation will also lead to rise in the real rate of interest. Fall in inflation
generally increases the real interest rate in the economy. Increasing real interest rates will
make it less attractive for borrowing as well as for investing which will make consumers to
save. When the economy will be depressed, the rise in real interest rate will be making
monetary policy less effective in nature.
For the above reasons, it can be said that zero percent inflation rate leads to lower
growth of the economy and will cause severe problems that are associated with deflation.
Therefore, it can be said that moderate inflation is good for the economy. The moderate 2
percent inflation is good for the economy since
Inflation causes large circulation of money and therefore it will be helping people to
provide incentive for production. Some of the large as well as small scale industries come up
as a result of moderate inflation. Therefore, low inflation is much better compared to
deflation in the economy which results with severe recessions. Targeting a zero inflation have
various risks in the economy. A moderate inflation also helps the economy by making the
wages in the labor markets more flexible in nature. The 2 percent inflation in the economy
can also help in widen the scope for employment in the economy. It can also act as stimulus
for providing fill utilization of the resources.

ECONOMICS
In order to conclude it can be said that deflation or zero percent inflation is harmful
for the economy. In the similar way high rate inflation is also not beneficial to the economy.
A moderate inflation which is known to be 2 to 3 percent will stimulate various economic
activities. For this reason, the Reserve Bank of Australia choose to set the inflation target of 2
– 3 percent on average over the long term.