What is inflation, and how does it affect your cost of living?

Collage of people pointing out rising prices in a grocery basket.

Inflation is the rise in goods and service prices over time. Inflation is often expressed as a percentage to show how much the cost of goods and services has changed, i.e. an inflation rate of 5%. 

A little bit of inflation can be good for a country, since it means there’s healthy competition. However, if inflation is too high, it can push prices beyond the budget of ordinary people and hurt their cost of living

So let’s unpack what inflation is, why it happens, and how it affects you.

What is inflation?

Inflation is an increase in the price of goods and services, such as groceries, clothes, or utilities, over time. When prices go up, economists say they are ‘inflating’. 

It’s normal for economies to experience inflation, and prices can change for various reasons. 

What causes inflation?

Inflation is primarily caused by vendors raising their prices. For example, a supermarket may mark up the price of vegetables, or a landlord will charge their tenants higher rent. When lots of goods and services get more expensive, it drives inflation for the entire economy.

Businesses charge more for two main reasons: increased demand or limited supply.

If people want the same product, the intense competition (demand) drives up the price. 

On the flip side, anything that affects the supply chain, such as transport, storage, labour, or material costs, can create a shortage, which makes a product limited and thus more valuable.

Supply demand inflation graph

For example, let's say Santa’s Workshop creates a new toy.

Every kid wants one, so the toy becomes extremely popular. To meet demand, Santa’s Workshop will boost production of the toy. But making more toys is expensive, so they raise the final sale price to cover the costs. 

However, Santa’s Workshop experiences a few supply chain issues. Toy parts become more expensive to import to the North Pole, the Elves go on strike, and the price of electricity goes up. All this means they can’t make as much of the popular toy, so Santa’s Workshop increases the toy price to cover these extra charges, make more of the toy, and meet demand.

Why is inflation so high right now?

Over the last two years, Australia has experienced high inflation. The price of goods and services rose far too fast and ‘overheated’ the economy. 

Inflation erodes the value of people’s savings and hurts their purchasing power over time. This is because it takes more money to buy essential goods than it used to, so the value of someone’s dollar is worth less than it used to be. This raises the overall cost of living. Yikes.

There are a few reasons why inflation has been so high in the last two years, but the primary culprits are corporate profiteering, supply chain disruptions due to global conflict and the COVID-19 pandemic, and, to a lesser extent, high demand. 

For example, the Russian invasion of Ukraine hurt the supply of petroleum, gas, and grain crops to Europe, which made food production, storage, and transportation more expensive. This created a ripple effect that eventually reached supply chains in Australia.

Is inflation the same as a recession?

High inflation is not the same thing as a recession.

A recession is a period of slow or low economic activity, usually marked by two consecutive quarters where a country’s GDP shrinks (called a ‘technical’ recession). Inflation is just a rise in prices. 

A recession is more about the volume of spending in the economy, while inflation is more about prices. People may still buy things despite the high costs, so inflation doesn’t always mean low spending. 

However, this doesn’t mean inflation and recessions aren’t related. In fact, inflation can sometimes cause recessions, and recessions can sometimes worsen inflation. 

For example, if inflation go unchecked for too long, people may close their wallets, stop spending, and crash the economy through a significant plummet in demand. In this way, sometimes recessions "correct" out of control price rises. 

How is inflation calculated?

In Australia, the main inflation tracker is the Consumer Price Index (CPI), which measures the change in an essential ‘basket’ of goods, including food, transport, and healthcare. The Australian Bureau of Statistics releases monthly and quarterly CPIs. 

There are a few ways to measure inflation based on the CPI. There’s headline inflation, which is the overall change in the price of goods and services, and trimmed mean inflation, which removes the most volatile goods and services from the CPI. The ABS will do this by cutting the top and bottom items for a more accurate look at "core", or underlying, inflation. 

Trimmed mean inflation is the preferred number for economists and policymakers because it cuts out "economic noise", such as seasonal price changes or short-lived trends. Headline inflation just tends to be quoted more in the news because it looks often looks higher, and therefore, scarier. 

For example, between March 2022 and March 2023, the overall CPI rose 7.0%, meaning headline inflation was 7.0%. The trimmed mean inflation rate, however, was 6.6%.

Is inflation good or bad?

Inflation is an academic term, meaning it’s not inherently good or bad. Inflation is just inflation. However, inflation can affect people’s livelihoods and the cost of living, so the effects of inflation can be good or bad. 

Surprisingly, a certain amount of inflation in the economy is desirable. The Reserve Bank of Australia sets an inflation target band of 2% to 3%, which indicates a healthy amount of competition and keeps the Australian dollar in line with other currencies. 

If inflation gets too low, it could mean a dollar collapse or recession. If inflation gets too high, it stretches people’s budgets and hurts their cost of living. 

So a certain amount of inflation is good. However, too much or too little can be bad.

How does inflation affect interest rates?

Inflation and interest rates on financial products like home loans, savings accounts, and term deposits are closely linked.

In times of high inflation, interest rates tend to rise. If inflation is too low, interest rates will come down. This happens because the Reserve Bank of Australia (RBA) changes its monetary policy.

The RBA’s job is to watch the economy and smooth the highs and lows of the business cycle. If anything gets too extreme, the RBA adjusts its monetary policy to protect the welfare of Australians.

The RBA does this by setting official interest rates, also called the cash rate. Banks and lenders use the cash rate as a benchmark for their interest rates. If the cash rate rises, so do rates on mortgages and deposits. If the cash rate falls, the reverse happens.

The cash rate lets the RBA control the amount of cash in the economy. If rates rise, personal loans and mortgages become expensive to borrow, so people stop taking them out, instead parking their cash in savings accounts. If rates fall, loans become cheap and deposits less attractive, so people spend their cash and give the economy extra juice. 

Right now, the RBA is trying to slow down inflation. The graph below shows how variable interest home loans have risen with every RBA decision.

This has really hurt mortgage holders, but on the bright side, savers have better options to compare. 

Is inflation slowing down in Australia?

The worst of high inflation is over in Australia for now. CPI figures from the last few months show a significant slowdown in price growth, as well as a dip in consumer spending and sentiment.

While these are promising signs, inflation is still too high for the RBA’s comfort. Indeed, most economists estimate inflation won’t fully slow until late 2024.

How can you handle inflation?

Dealing with inflation can be tricky because price rises affect everyone differently. Not everyone has savings they can fall back on, and not everyone earns the same amount of money. (The ABS actually measures how inflation affects different people through their Living Cost Indexes). 

However, while you can’t control prices, you can control how you spend your money. Namely:

  • Make a budget.
  • Stick to it.
  • Grow your savings. 

For example, you can try out these ten ways to handle the rising cost of living, or download one of these budget apps

Once you accumulate a nest egg, you can compare high-interest savings accounts to take advantage of rising interest rates. 

You can also break down your finances with our free calculators.

Inflation FAQs

Is inflation the same as the CPI?

The primary method of measuring inflation in Australia is the Consumer Price Index (CPI), so the two ideas are often used interchangeably. If the CPI rises 7.0%, then headline inflation is 7.0%.

Are inflation and employment rates related?

Inflation and employment support each other, but they aren’t the same.

High employment can sustain inflation because everyone has enough income to meet rising prices; thus, price growth never slows.

Inflation slows or reverses if employment is too low because not everyone can afford higher prices.

Can inflation cause a recession?

Absolutely. If inflation gets too out of hand or goes on too long, it embeds in people’s expectations and becomes self-sustaining.

This hurts people’s savings and spending habits over time, which can eventually push the economy into a recession. 

However, inflation doesn’t have to lead to a recession. Other factors, like high employment rates, can sometimes delay or offset a recession entirely because people have enough money to cope with rising prices. 

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