The Rationale Behind RBA's 2%-3% Inflation Target: A Detailed Analysis

This essay provides an in-depth analysis of the Reserve Bank of Australia's (RBA) inflation target of 2%-3%, established in 1992-1993. The target was set to ensure stable economic growth, addressing concerns from the high inflation periods of the 1970s and 1980s. The essay highlights that this range is intended for the medium to long term, allowing for short-term deviations. It also notes the alignment of Australia's target with those of other developed nations, like the UK, and emphasizes the importance of a low inflation target to prevent negative real GDP growth and maintain international competitiveness. The analysis considers macroeconomic implications, such as employment and cost competitiveness, concluding that the RBA's target was strategically chosen to balance economic stability and growth.

ECONOMICS
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The inflation target for RBA has been set within the narrow range of 2%-3% when the
inflation targeting system was introduced in 1992-1993. The reason for fixing this target is
because it was felt at the time that this level of inflation would ensure that a stable economic
growth could be maintained. Further, it is imperative to note that the above range is meant for
medium to long term and it is quite possible that in the short term, there could be deviations
from the above range. The fixing of the above defined inflation rate may also be linked to the
issue of high inflation that most countries faced during the 1970’s and 1980’s including
Australia. The historical CPI movement for Australia is indicated in the graph below.
Source: Reserve Bank of Australia Website
From the above graph, it is evident that Australia did witness its own issues with regards to
hyper inflation during the 1970-1990 period when at times, the CPI crossed 10% which
effectively meant that the real growth in GDP was negative and additionally the value of
money was eroding. As a result, it was felt at the time that keeping inflation target low was
pivotal to provide a stable economic growth.
Further, the target was also linked to the empirical observations on the part of the RBA with
regards to Australia and globally (especially the developed countries) in relation to the

desired inflation rate which do not lead to overheating of the economy and allow for optimal
& sustainable use of the resources available. Besides, the target fixed by the RBA in 1991
was in line with the inflation target fixed by other central banks of developed countries. UK
is an example in this regards which also introduced inflation targeting at about the same time
as Australia and chose the target inflation as 2.5%. However, considering the fact that to
achieve a certain value of inflation can be quite difficult, hence a narrow change was defined.
Further, an inflation target of 2%-3% would make sense considering the fact that developed
nations typically have a stable price regime which is more immune from demand and supply
shocks and thereby better equipped to keep the prices stable. As a result, typically higher
inflation is visible in case of developing and underdeveloped nations. In case of developed
countries such as Australia, the long term inflation targets cannot be fixed at high value since
this could lead to negative real GDP growth as the growth rates typically are quite low.
A high inflationary target could also potentially have macroeconomic implications
particularly in terms of employment and cost competitiveness. This is because higher
inflation target would imply a more liberal monetary policy which would provide a stimulus
to the economy and hence increase demand. This could potentially create a shortage of labour
and lead to high wages which would hurt the competitiveness of the products and services in
international markets. Considering the various aspects cited above, it was decided by the
RBA to fix the target from 2%-3% in 1991.