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The Influence Of Inflation On Forex Profit Potential – Inflation is an increase in the prices of goods and services. The best-known measure of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households (see Definition: Inflation and Its Measurement). The CPI is a measure of inflation used by the Reserve Bank of Australia in its inflation target, where it aims to keep annual consumer price inflation between 2 and 3 percent, on average, over time (see Explainer: Australia’s Inflation Target). Other measures of inflation are also analyzed, but most measures of inflation move similarly over the long run.
As their names suggest, “demand-pull inflation” is caused by developments on the demand side of the economy, while “cost-push inflation” is caused by the effects of higher input costs on the supply side of the economy. Inflation can also result from ‘inflationary expectations’ – that is, what households and businesses think will happen to prices in the future can affect actual prices in the future. These different causes of inflation are taken into account by the Reserve Bank when it analyzes and forecasts inflation.
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Demand-pull inflation occurs when the total demand for goods and services (ie, “aggregate demand”) increases to exceed the supply of goods and services (ie, “aggregate supply”) that can be sustainably produced. Excess demand puts upward pressure on prices for a wide range of goods and services, and ultimately causes inflation to rise – that is, it “raises” inflation.
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Aggregate demand may increase because spending by consumers, businesses, or the government increases, or because net exports increase. As a result, demand for goods and services will increase relative to their supply, providing firms with the opportunity to raise prices (and their margins—which is their markup over costs). At the same time, firms will try to hire more workers to meet this additional demand. Due to increased demand for labor, firms may have to offer higher wages to attract new employees and retain existing employees. Firms may also raise the prices of their goods and services to cover higher labor costs.
More jobs and higher wages increase household incomes and lead to higher consumer spending, which further increases aggregate demand and firms’ ability to raise prices for their goods and services. When this happens in a large number of businesses and sectors, it causes inflation to rise.
The opposite will happen when aggregate demand decreases; Firms with less demand will either stop hiring or lay off staff, meaning less staff are needed. This puts upward pressure on the unemployment rate. More workers looking for work means firms can offer lower wages, putting downward pressure on household incomes, consumer spending, and the prices of their goods and services. As a result, inflation will decrease.
The supply of goods and services that can be sustainably produced is also known as the economy’s potential output or full capacity. At this level of output, factors of production such as labor and capital (which includes the machinery and equipment that firms use to produce their goods and services) are used as intensively as possible without causing inflationary pressure. When aggregate demand exceeds the economy’s potential output, this will put upward pressure on prices. When aggregate demand is below potential output, this will put downward pressure on prices.
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So how can we measure how far the economy is from its potential output (or full capacity) and what this means for inflation? Although we can measure aggregate demand fairly accurately from quarter to quarter using gross domestic product (GDP) data from national accounts (see definition: economic growth), potential output is not directly observable—that is, we must infer it. Other evidence about the behavior of the economy. For example, just as there is a level of output where inflation is stable, there is also a level of unemployment that corresponds to stable inflation. It is known as the non-accelerating inflation rate for unemployment or NAIRU for short (see definition: non-accelerating inflation rate for unemployment (NAIRU)). When unemployment is below the NAIRU, inflation will increase and when it is above the NAIRU, inflation will decrease.
Budget inflation occurs when the total supply of goods and services that can be produced in an economy (aggregate supply) falls. A drop in total supply is often caused by an increase in the cost of production. If aggregate supply falls but aggregate demand remains the same, pressure is put on prices and inflation—that is, inflation is higher.
An increase in the price of domestic or imported products (such as oil or raw materials) increases production costs. As firms face higher costs of producing each unit of output, they tend to produce lower levels of output and raise the prices of their goods and services. This can affect other goods and services by increasing their prices. For example, an increase in the price of oil, which is the main income in many sectors of the economy, will initially lead to an increase in the price of gasoline. However, higher gasoline prices will also make it more expensive to transport goods from one place to another, which in turn will drive up prices for things like groceries.
Cost-related inflation can also occur due to supply disruptions in specific industries – for example, due to unusual weather or natural disasters. Large cyclones and floods occur periodically, damaging large amounts of agricultural produce and causing significant increases in processed food and both food and restaurant prices, leading to temporary periods of higher inflation.
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Exchange rate movements can also affect prices and affect inflation outcomes. A decrease in the value of the domestic currency – or depreciation – will increase inflation in two ways. First, the prices of goods and services produced abroad increase compared to those produced in the country. Consequently, consumers pay more to buy the same imported products, and firms that rely on imported materials in their production processes pay more to buy those products. Rising prices of imported goods and services directly contribute to inflation through the channel of rising costs.
Second, currency depreciation stimulates aggregate demand. This happens because exports become relatively cheap for foreigners, leading to an increase in demand for exports and an increase in aggregate demand. At the same time, domestic consumers and firms reduce their consumption of relatively more expensive imports and buy more domestically produced goods and services, which again leads to an increase in aggregate demand. This increase in aggregate demand puts pressure on domestic production capacity and increases the opportunity for domestic firms to raise prices. These price increases indirectly contribute to inflation through the demand pull channel.
In terms of imported inflation, the exchange rate has a greater impact on inflation through its impact on exports and the prices of imported goods and services (known as tradable goods and services), while the prices of non-tradable goods and services are more dependent. on internal events.
Inflationary expectations are the beliefs that households and firms have about future price increases. They are important because expectations of future price increases can influence current economic decisions, which can affect actual inflation outcomes. For example, if firms expect future inflation to be higher and act on these beliefs, they may raise the prices of their goods and services at a faster rate. Similarly, if workers expect future inflation to be higher, they may demand higher wages to compensate for the expected loss of purchasing power. This behavior, sometimes called the “psychology of inflation,” can contribute to a higher rate of actual inflation so that inflation expectations become self-fulfilling.
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Given that inflationary expectations can affect real prices and wages, the degree to which inflationary expectations are “hardened” affects future inflation outcomes. For example, if households and firms expect inflation to return to the central bank’s inflation target at some point in the future, regardless of what current inflation is, we describe their expectations as the inflation target. When expectations are firm, a period of higher inflation—perhaps driven by rising spending—will not cause households and firms to change their behavior, and as a result, inflation is likely to eventually return to its target. But if the inflation psychology of households and firms changes and inflation expectations move towards the central bank’s inflation target (i.e. the future and adjust their behavior accordingly. Therefore, it is much easier for the central bank to manage inflation if inflation expectations are anchored and not unfounded.
Long-term inflation expectations remain little changed in response to periods of high inflation. Households and firms expect the increase in inflation to be temporary and will not change
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