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.