Inflation and firms’ price-setting behaviour In the medium-to-long run, the average rate of inflation is determined by the rate of nominal expansion permitted by the monetary authority. But over shorter horizons, decisions taken by businesses – in particular, about wages and prices – affect quarter-to-quarter fluctuations in inflation and, more generally, how demand pressures feed through to inflation. Economic policymakers draw on a number of ways of thinking about those influences on inflation dynamics. There is no model that can, uniquely, capture the richness of the real world. But surprising though it may be to some, one of the ways in which we think about firms’ price-setting behaviour would be familiar to anyone running a business. Namely, that firms charge a mark up, or profit margin, over the marginal costs of their various inputs – labour, capital, raw and intermediate materials, etc – with both the mark up and costs varying according to current and prospective demand conditions. This is represented schematically, indeed crudely, in Diagram 1. The key feature is that when demand rises and firms utilise their capacity more fully and add to their labour force, their costs and prices tend to rise. That might involve old-fashioned ‘cost-push’ inflation, with firms raising prices to maintain margins in the face of increased (marginal) costs. Or firms might initially be able temporarily to raise margins, with labour and other costs later ‘catching up’. In either case, firms and wage bargainers will be influenced by what they think is going to happen to inflation in the future.

While measures to reduce financial exit costs have met with some success in reducing switching barriers within the financial industry, responding to other factors that discourage consumers from switching to a superior product or financial service has been more challenging. Such factors include the additional effort required to switch financial service providers or products arising from the higher marginal cost of switching. Finally, the measures to strengthen redress mechanisms are also contributing to the enhanced capability of financial consumers, by providing an expedient and cost–effective means for consumers to assert their rights and protect their interests. Effective redress mechanisms also increase consumer confidence in using financial services, while serving to strengthen market discipline. Looking ahead, strategies to further strengthen these foundations are likely to be significantly influenced by two important developments. The first is the broader application of behavioural finance so as to better understand and identify the levers that contribute to better financial decisions in the different circumstances. Recent insights from the study of behavioural finance suggest that emotional and psychological associations with finance are as powerful as the intellectual grasp of how to make wise financial choices. This will have important implications for the design and implementation of both consumer protection policies as well as financial capability strategies. We have found that providing consumers with relevant information in Malaysia did not always lead to better decisions. This was frequently because it was not easy to understand the information and there was also too much of it.