Inflation is a term thrown around in the media and by economists, but what does it mean?
Inflation can be defined as a sustained increase in the general level of prices for goods and services. It is measured using the Consumer Price Index (CPI), which looks at the changes in prices of a basket of goods and services over time.
In this blog post, we will take a closer look at inflation, including:
- What is inflation?
- Who sets the inflation rate?
- What factors drive inflation?
- What does inflation impact?
- How to measure inflation
- What is stagflation?
What is inflation?
Inflation is a term that describes the rate at which prices for goods and services rise. It is often used as an indicator of the health of an economy.
When inflation is low, it indicates that the economy is growing at a sustainable pace.
When inflation is high, it can be a sign that the economy is overheating and may soon experience a downturn.
Inflation is not necessarily bad, particularly in a period of historically low unemployment, which Australia is currently enjoying. This, in turn, can further stimulate the economy and lead to an increase in wages, property prices, etc. However, the RBA has a fine tightrope to navigate, keeping inflation in check while not squeezing too hard and fast, resulting in an economic recession.
There are two main types of inflation:
- Demand-pull inflation, and
- Cost-push inflation.
Demand-pull inflation
Demand-pull inflation occurs when there is too much money chasing too few goods. This can happen when the economy grows too quickly, or the government prints too much money.
Cost-pull inflation
Cost-push inflation happens when costs go up, such as when oil prices rise or a drought drives up food prices.
Who sets the inflation rate?
The Reserve Bank of Australia (RBA) monitors inflation and has an ‘inflation target’ which aims to keep consumer price inflation in the economy to 2-3% on average.
To meet this target, the Reserve Bank uses monetary policy – adjusting interest rates up or down – to influence inflation. The RBA’s objective is to keep inflation in the economy low and stable.
In early May, the RBA predicted that inflation would hit 6% by the end of 2022 before easing to 3% in mid-2024.
Controlling inflation helps preserve the value of money, encouraging solid and sustainable economic growth.
What factors drive inflation?
Inflation is driven by several factors, including:
- The money supply: If the money supply grows too quickly, it can lead to inflation. This is because there will be more money chasing the same amount of goods, leading to higher prices.
- Demand: If demand for goods and services is high, prices will increase. This can be due to population growth or strong economic growth.
- Supply: If the supply of goods and services decreases, prices will increase. This can be due to a natural disaster or production problems.
- Costs: If costs go up, such as the cost of raw materials or fuel, this can lead to inflation.
What does inflation impact?
Inflation impacts many things, including:
- Cost of living
- Cost of doing business
- Borrowing money
- Mortgages
- Plus, all other facets of the economy.
Inflation can have both positive and negative impacts.
Positive impacts:
- It encourages people to spend money rather than save it, as they will get less value for their money in the future. This can boost economic growth.
- It reduces the real value of debt, making it easier to repay.
- It can help businesses as it increases the prices of their goods and services.
Negative impacts:
- It reduces people’s purchasing power, as their money will buy less. This can lead to lower living standards.
- It can cause uncertainty and discourage investment as businesses still determine what prices will do in the future.
How to measure inflation
Consumer price index
The most commonly used indicator of inflation is the Consumer Price Index.
Consumer Price Index, or CPI, measures the percentage change in the price of a basket of goods and services consumed by households.
The Australian Bureau of Statistics (ABS) calculates Australia’s CPI for thousands of items categorised into 11 groups.
These 11 categories and their respective weight are:
- Housing (23%)
- Food and non-alcoholic beverages (16%)
- Recreation & culture (13%)
- Transport (11%)
- Furnishings, household equipment and services (9%)
- Alcohol & tobacco (8%)
- Health (6%)
- Insurance & financial services (6%)
- Education (4%)
- Clothing & footwear (3%)
- Communication (2%)
These categories and their weight are decided upon based on what Australians spend their income on. The more they spend on a particular item, the greater the weight in the Consumer Price Index.
Producer price index
The producer price index (PPI) measures the average price change received by domestic producers for the sale of their output.
The PPI measures price changes at all stages of production, from raw materials and components to finished manufactured goods. It, therefore, provides insights into inflationary pressures before they reach consumers.
Like the CPI, The producer price index is measured and released monthly by the Australian Bureau of Statistics (ABS).
The Reserve Bank of Australia (RBA) measures inflation using the CPI and PPI. However, they place more emphasis on the CPI when setting interest rates. This is because the CPI better reflects changes in the prices that households pay for goods and services.
What is stagflation?
Stagflation is a term used to describe a situation where inflation is high but economic growth is low. This can lead to higher unemployment and lower living standards.
While increased oil prices often cause stagflation, it can also be caused by other factors, such as poor economic management or a natural disaster.
Stagflation can be challenging to deal with because standard economic policy measures (such as interest rate cuts) may not be effective.
Financial Health Check for Businesses
In conclusion, inflation is a sustained increase in the price level of goods and services in an economy—various factors, including excess money supply, high oil prices, and demand-pull inflation, cause it. Inflation can be measured using the Consumer Price Index.
Considering the brave new inflationary world, it may be time for businesses to reassess their situation, whether price increases can be regarded as/passed onto the public and have a general “financial health check” – which Ledge Finance can undoubtedly assist you with. Give us a call at (08) 6318 2777 or email us at secure@ledge.com.au.
Please keep in mind that the information provided here is general in nature and does not constitute financial, tax or other professional advice. You should consider whether the information is appropriate for your needs and seek professional advice before you make any decisions.
