What Is Inflation?

what is inflation

Inflation is a rise in prices across an economy. This is the opposite to deflation, which describes a fall in prices across an economy.

Inflation does not refer to a single item. Instead, inflation refers to a basket of everyday consumer goods and services. Examples of consumer goods and services are housing costs, groceries, alcohol, education, and health. 

Let’s use an example to better understand inflation. Imagine that the price of a bag of rice is higher than what it was six months ago. Over this same period, assume the price of all other consumer goods and services stays the same.

We don’t say “rice has experienced inflation.” Instead, we say “the economy has experienced inflation.” That is because rice belongs to the basket of everyday consumer goods and services that is used to measure inflation.

In our above example, the price of everything else in the basket remained the same. And so, because of the increase in the price of rice, the price of the entire basket increased over that six-month period. Therefore, we know there is inflation in the economy.

Understanding Inflation

Why should you care about inflation? Because inflation has a very real impact on your life. That’s because inflation increases your cost of living and reduces the value of your money.

Today, if you earn $1,000 per week, you’ll likely be able to cover your everyday costs such as rent, groceries, and private health insurance.

Now imagine a scenario where a few years from now you’re still earning $1,000 per week. If the inflation rate has been high over this period, you won’t be able to afford those same everyday costs. Because of inflation, your money won’t be able to go as far as what it does today, even though you’re earning the exact same amount. Your purchasing power has fallen. (More on ‘purchasing power’ later.)

How Is Inflation Measured?

In Australia, price data is collected by the Australian Bureau of Statistics (ABS). Every quarter, the ABS collects price information from supermarkets, energy providers, real estate agents, and other areas of the economy.

This process lets the ABS know what the price of the basket of goods and services is. Once it knows this, the ABS compares this current basket price to an earlier basket price.

By comparing the current basket price to the basket price from a year ago, the ABS will determine annual inflation. It will also compare the current basket price to the basket price from three months (i.e., a quarter) ago. By doing this, the ABS can calculate quarterly inflation.

When the basket price is higher than an earlier basket price, there is inflation in the economy. When lower, there is deflation.

The basket of goods and services that the ABS calculates every quarter is known as the Consumer Price Index (CPI). Every good and service in the CPI basket belongs to a category. Every category belongs one of 11 groups. Watch the below explainer from the Nugget’s News YouTube channel to go deeper into inflation.

Inflation Rate, Explained

Inflation is almost always expressed as a percentage. This figure is known as the ‘rate of inflation’ or ‘inflation rate’. The inflation rate is the percentage increase in the CPI compared to an earlier CPI.

When you hear someone say “annual inflation is 2 per cent,” they mean the inflation rate is 2 per cent. That is, the CPI has increased by 2 per cent compared to a year ago.

What Causes Inflation?

Broadly speaking, inflation has two causes. These are known as demand-pull inflation and cost-push inflation.

Demand-Pull Inflation

To understand demand-pull inflation, you need to know a bit about how the economic concept of demand and supply works. In simple terms, if the supply of a product remains the same and demand for the product increases, the product’s price will increase.

For example, imagine you are an apple grower. You normally sell a bag of apples for $5. One day, a scientific paper is published and it concludes that if people eat one apple per day, the rate at which they age will slow down dramatically. As a result, there is a surge in demand for apples.

As an apple grower, you have a limited number of bags of apples to sell. Apples take several months to grow. You can’t just snap your fingers and “produce” thousands of apples.

Consumers know there is a limited supply of apples. Some are so desperate to get a bag of apples that they offer you $6. You have a feeling there will be more people willing to pay $6, so you decide to lift the price of a bag of apples from $5 to $6.

This price rise of $1 is the equivalent of a 20-per-cent increase. All of this has happened because of an increase in demand for apples. This is an example of demand-pull inflation. Put another way, the surge in demand has pulled prices up.

Cost-Push Inflation

Whereas demand-pull inflation is all about how demand affects prices, cost-push inflation has everything to do with the supply side of things.

Cost-push inflation typically happens when the cost to produce a good or service increases. In response to this, the producer bumps up the selling price for that good or service. (If they don’t do this, then their profit margin will fall. Falling margins means there is a greater risk of going out of business.)

Production costs go up for many reasons, such as company tax rates, wages, and cost of inputs. Whenever any of these increase, producers will tend to raise the price that they sell their goods or services for.

With cost-push inflation, prices rise because it has become more expensive to produce a certain good or service. That is, rising costs are pushing prices up (i.e., cost-push inflation).

How Do Central Banks Manage Inflation?

Central banks use monetary policy tools in an effort to manage the economy’s inflation rate. Put another way, the decisions made by central banks can influence the prices of consumer goods and services.

In Australia, the Reserve Bank of Australia (RBA) is the central bank. One of the main goals of the RBA is to keep the inflation rate at a certain level. This is what the RBA calls its inflation target, which is an annual range of 2–3 per cent.

If the inflation rate was 6 per cent, for example, the RBA would have the option to use its monetary policy tools to reduce the growth of money and credit (i.e., borrowed money). This would “slow down” the economy and bring the inflation rate back down towards the inflation target.

Protecting Your Money From Inflation

You’ll likely hear inflation referred to as a ‘hidden tax’. To understand this, you must know what ‘purchasing power’ is. Purchasing power is the amount of goods and services that can be purchased with a unit of currency. (Basically, purchasing power is all about “how far your money goes”.)

Inflation is a ‘hidden tax’ because it eats away at your purchasing power over time. Say you have $100,000, for example. You keep this in a bank account for a year and you earn an interest rate of 1 per cent. A year later, you have $101,000 in your account.

Over this time, annual inflation has been 3 per cent. A year ago, your $100,000 could have bought you $100,000 worth of goods and services. If you wanted to buy those exact same goods and services today, you would need $103,000—which you don’t have.

(Of course, this is a very simplistic example. Some goods and services increase in price faster than others. Some goods and services aren’t counted in the basket of consumer goods and services.)

Generally speaking, people protect their money against inflation by investing in a diversified portfolio. To directly protect against inflation, there are government bonds and other securities that are adjusted to account for inflation. For example, the Australian government issues Treasury Indexed Bonds.

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