If on the other hand, the real inflation rate is above both targeted and past values, the RBA could change its current approach and implement more aggressive means of decreasing inflation, such as reducing the amount of money in circulation or increasing the interest rates. A higher interest rate will reduce the amount of money in circulation by making the goods and services less accessible to the public. This in turn will materialize in a reduced demand for currency, reducing as such the levels of inflation.
3. Reducing the Expansionary Gap
An expansionary gap, often known as an inflationary gap, generally occurs at changing stages of the business cycle and is generally pegged to high levels of inflation. It can best be understood in terms of production and input in the meaning that it occurs when the final output of production is larger that the output of the labor force. "An inflationary gap exists when equilibrium income is greater than full employment income. In such a case, businessmen would compete against one another to get resources with which to produce the output that is demanded, and costs would rise, with prices following them up" (King).
Similar to the reduction of the inflation rate, the Reserve Bank of Australia will most likely employ a strategy of contraction in order to reduce the expansionary gap. Some measures in this direction include:
Reducing the purchases made by governments in order to reduce demand for certain products or services -- this will have the sought out benefit of reducing the amount of money in circulation, but will also have the disadvantage of limiting the development of the respective industries or sectors
Increases in taxes -- similar...
The positive effect is that of reducing the amount of money in circulation and as such the levels of inflation and the expansionary gap; on the other hand however, the limitation is that of a discouragement of certain industries and economic sectors
4. Conclusions
Today's financial institutions use the inflation rate to assess the status of a given economic system. Efforts are generally being made to reduce this inflation rate and the classic means to achieving this desiderate is through the implementation of larger interest rates.
