I

Inflation – Comprehensive Study Notes

Inflation: Core Definitions and Everyday Relevance

  • Inflation a persistent and appreciable increase in the general level of prices

    • It can be described as an increase in the cost of living.

    • It can be described as a decline in the purchasing power of money.

  • Everyday understanding: people notice rising prices, worry about saving, and worry about maintaining living standards. Older generations often reference “cheap things back in the day” as a way to describe inflation.

Official Definition and Measurement Framework

  • Official definition (to know off by heart): A persistent and appreciable rise in the general level of prices.

  • Measurement tool: the Consumer Price Index (CPI).

  • CPI basics:

    • The CPI tracks the average price consumers pay over time for a representative basket of goods and services.

    • The CPI measures how much prices change on average, not all prices rise equally; some rise more, some fall.

    • Government statisticians create a shopping list (basket) of items that a typical Australian household purchases.

  • The basket is called the regimen; its price is a measure of the average price level in the economy.

  • Inflation rate is the annual percentage increase in the average price level, calculated as the percentage change in the price of the basket.

ext{CPI} = igg( rac{ ext{current value of regimen}}{ ext{base year value of same regimen}}igg) imes 100
ext{Rate of inflation} = igg( rac{ ext{CPI}{Year2} - ext{CPI}{Year1}}{ ext{CPI}_{Year1}}igg) imes 100

  • Example: If the basket price rose from $100 last year to $102 this year, the inflation rate is

ext{Inflation} = igg( rac{102 - 100}{100}igg) imes 100 = 2 ext{
%}

  • The CPI is used to measure the general price level; it is not a perfect measure of every individual price change.

What is in the CPI basket and how it’s weighted

  • The basket (regimen) is weighted to reflect the share of spending on each category in a typical household budget.

  • Key category weights (Australia):

    • Housing: 23%

    • Alcohol and tobacco: 7%

    • Food and non-alcoholic beverages: 16%

    • Insurance and financial services: 6%

    • Recreation and culture: 13%

    • Health: 5%

    • Education: 4%

    • Transport: 10%

    • Clothing and footwear: 4%

    • Furnishings, household equipment and services: 9%

    • Communication: 3%

  • The government reassesses the basket content every 6 years by surveying thousands of households to determine what they are buying.

How to calculate the CPI and the inflation rate in practice

  • Steps to calculate the CPI once the basket is defined:

    • Assign a weighting to each category according to its importance in the budget.

    • Compute the total value of the basket in the base year and in the current year.

    • The CPI is the current value divided by base-year value, times 100 (as shown above).

  • Renormalised example with a fixed base: If the current basket value is 120 and the base-year basket value is 100, then

ext{CPI} = rac{120}{100} imes 100 = 120

  • Once you have CPI values for two years, the inflation rate is:

ext{Rate of inflation} = igg( rac{ ext{CPI}{Year2} - ext{CPI}{Year1}}{ ext{CPI}_{Year1}}igg) imes 100

  • CPI components and composition illustrate that the overall index is a weighted average, not a simple sum of price changes.

Headline vs Underlying inflation: what’s the difference and why it matters

  • Headline inflation:

    • The % change in prices over time measured by the CPI, sometimes called the consumer inflation rate.

    • It is calculated from raw CPI data and includes all items, regardless of short-term fluctuations.

  • Underlying inflation:

    • The headline rate with one-off or seasonal factors removed to reveal the more persistent trend.

    • It excludes items with particularly large price changes (either frequent or in a given quarter) that can distort the view of the broader economy.

  • Why both matter:

    • Headline shows the actual observed inflation in the short term.

    • Underlying inflation provides a cleaner signal of the sustained inflation trend and helps with policy guidance.

  • Examples of volatile items commonly removed:

    • Supply disruptions (e.g., weather events like Cyclone Larry affecting banana prices).

    • Infrequent tax regulation changes (e.g., introduction of GST affecting many prices).

Classifications: disinflation, deflation, hyperinflation

  • Disinflation: slowdown in the rate of inflation.

  • Deflation: fall in the overall price level.

  • Hyperinflation: inflation exceeding 100% per year.

Types of inflation: the two main mechanisms

  • Demand-pull inflation (aggregate demand exceeding supply):

    • Causes prices to rise due to high overall demand.

    • Mechanism: AD shifts to the right, as spending (C + I + G + (X - M)) increases.

    • Consequences: higher price level and higher GDP in the short run; can lead to a boom but may overshoot capacity.

    • Arrow of causation: Increased spending leads to higher production, more jobs, higher wages, and further demand.

  • Cost-push inflation (costs of production rise):

    • Causes prices to rise due to higher production costs (e.g., oil prices, energy, wages, raw materials).

    • Mechanism: AS shifts to the left; output falls while prices rise (stagflation when inflation and unemployment rise together).

    • Contagion effect: higher costs spread to other sectors, further raising prices.

  • Inflation can also be driven by expectations (inflation psychology):

    • If producers expect higher costs, they raise prices preemptively.

    • If households expect higher inflation, they demand higher wages.

    • These behaviors can make inflation self-fulfilling and harder to control.

  • A commonly cited quote related to inflation dynamics: “Double-digit inflation is a terrible thing.” (Paul Volcker, 1979–1987).

Factors that affect inflation (summarised)

1) Growth in China, India, and other Asian countries

  • Cheaper mass-produced goods, abundant cheap labour, and growth of free international trade kept inflation low in recent times.

2) Exchange rate

  • Before mid-2013 the Australian dollar was relatively strong, making imports cheap and boosting demand for imported goods.

  • A weaker Australian dollar later raises import costs and can push up inflation.

  • The exchange rate is determined by demand for and supply of the dollar; more exports can raise the dollar’s value.

3) Unit wage rates

  • Wages rising in line with productivity can keep costs under control.

  • Skilled shortages push wages higher, which can raise inflation.

  • Wage growth in Australia has been around 2% historically, rising to above 3% as inflation embedded.

4) Competition

  • Competitive markets pressure producers to be efficient, which can lower costs and prices.

  • Free trade continues to underpin lower inflation across decades.

5) Regulation

  • Government red tape and mandatory compliance raise production costs and can push prices higher.

  • More paperwork and training requirements add to costs for firms.

6) Changes in indirect taxation

  • Indirect taxes raise prices at the point of purchase; elasticity affects who bears the tax burden.

  • GST changes historically caused price increases (e.g., GST introduction in 2000).

7) Increases in input costs

  • Oil and energy price increases raise production costs across the economy.

  • Supply-side shocks (e.g., pandemic-related shutdowns) contribute to cost-push inflation.

Impacts and implications of high inflation

  • Economic growth and living standards:

    • Stable inflation (around 2–3%) is viewed as healthy; it supports consumption and investment.

    • High inflation reduces real income and purchasing power, lowering material living standards.

    • Example: 5% inflation erodes purchasing power by roughly 5% for a year.

  • Redistribution effects (redistributive impact):

    • Unexpected inflation redistributes wealth between groups (lenders vs borrowers).

    • Fixed-income savers and pensioners are hurt as real income falls.

    • Borrowers may benefit because debts are repaid with money worth less in real terms.

    • Assets that rise in price during inflation (e.g., housing) can increase wealth for those holding them.

  • Output and growth effects:

    • Unexpected inflation can slow economic growth; real balances shrink, reducing consumption and investment.

    • Negative multiplier effects can reduce GDP below potential output and raise unemployment.

  • Uncertainty and decision-making:

    • Inflation creates uncertainty about future prices and costs, complicating planning for saving and investment.

    • Price illusion: households focus on nominal prices rather than real purchasing power.

    • May lead to misallocation of resources (e.g., investing in assets rather than productive capital).

  • Efficiency losses and costs of inflation:

    • Inflation can distort resource allocation toward assets whose prices rise with inflation (e.g., real estate, commodities).

    • “Shoe leather costs” (costs of adjusting to price changes) and “menu costs” (costs of changing prices) rise.

  • International competitiveness:

    • Higher domestic inflation relative to trading partners makes exports more expensive and reduces demand for them, affecting injections into the economy.

Inflation data for Australia: trends, data, and events (recent five years)

  • CPI index values (Australia):

    • 2020: 138

    • 2021: 133

    • 2022: 128

    • 2023: 123

    • 2024: 118

    • 2025: 113

  • Inflation rate interpretations (based on CPI changes):

    • 2020: around 8%

    • 2021: around 6%

    • 2022: around 4%

    • 2023: around 2%

    • 2024: around 0%

    • 2025: not shown in the data excerpt

  • Quarterly inflation rates (approximate pattern from the data):

    • Values include quarters with values such as ~1.6%, ~0.8%, ~8.0%, ~0.0%, and negative readings in some quarters, indicating volatility across the period.

  • Consumer inflation expectations (Melbourne Institute):

    • Jul 2021: 5.6%

    • Jul 2022: 4.9%

    • Jul 2023: 4.2%

    • Jul 2024: 3.5%

    • Jul 2025: not shown

  • Events that shaped trends (cross-cutting shocks):

    • COVID-19 lockdowns leading to demand collapse in 2020 and a subsequent surge in spending when economies opened up.

    • Demand-side shock in 2020 deflationary pressure followed by a rapid rise in inflation as savings were released and supply couldn't keep up.

    • Supply-side shocks due to global production slowdowns, higher input costs, and shipping costs rising dramatically (e.g., due to conflicts and transport disruptions).

    • Russia–Ukraine conflict raising global oil prices, impacting production costs and shipping routes; gas shortages affecting domestic energy costs.

    • Housing market dynamics driven by migration, housing demand, and construction material constraints contributing to CPI components.

  • Connections to macroeconomic concepts:

    • The inflation trend in Australia reflects a mix of demand-pull and cost-push pressures, plus global factors (exchange rates, commodity prices, and global supply chains).

    • The central bank’s inflation targeting and the 2–3% target framework are relevant when interpreting these fluctuations.

Practice questions: overview of the types and calculations

  • Practice question (a):

    • Given quarterly real GDP, CPI, and unemployment rate data for Sep-2021, Dec-2021, Mar-2022, Jun-2022, Sep-2022, Dec-2022, Mar-2023, compute:

    • i) Annual rate of inflation for March quarter 2023 (to one decimal place).

    • ii) Annual growth rate of real GDP for March quarter 2023 (to one decimal place).

  • Practice question: Explain two causes of the high inflation rate in Australia during 2024.

  • Practice question: Explain, with examples, the two types of inflation and justify which type is affecting Australia in 2025.

  • Practice question: Based on the CPI graph (Australia) identify the period of deflation.

  • Practice question: Explain why inflation fell to -0.3% in Q2 2020 and why it rose to 3.8% in Q1 2021.

Connections to foundational principles and real-world relevance

  • The CPI is a practical tool for policymakers to gauge price stability, real income, and cost-of-living changes.

  • Inflation interacts with unemployment via the Phillips curve intuition (short-run trade-off between inflation and unemployment when policies stimulate demand).

  • Real purchasing power, equity, and distributional effects are central to debates about inflation targeting and social welfare.

  • The global nature of inflation means that domestic outcomes depend on exchange rates, global commodity markets, and international supply chains.

Summary of key equations and definitions to memorize

  • CPI definition: ext{CPI} = igg( rac{ ext{current value of regimen}}{ ext{base year value of same regimen}}igg) imes 100

  • Inflation rate: ext{Rate of inflation} = igg( rac{ ext{CPI}{Year2} - ext{CPI}{Year1}}{ ext{CPI}_{Year1}}igg) imes 100

  • GDP identity (for macro context): GDP = C + I + G + (X - M)

  • Items removed in underlying inflation are those with large, temporary price changes due to lasting but not broad economic conditions.

  • Inflation targets: common macro policy aim is 2–3% inflation over the medium term (contextual, not a strict formula).

Connections to prior learning and practical implications

  • Understanding CPI construction helps interpret media reports about inflation and cost-of-living changes.

  • Recognising the difference between headline and underlying inflation aids in evaluating policy stance and the likely persistence of price changes.

  • Knowing the drivers (demand-pull vs cost-push, expectations, policy, and external shocks) helps explain why inflation behaves differently in different periods and countries.

  • The data on Australia’s CPI and inflation expectations illustrate how actual inflation can diverge from expectations and what factors shift these expectations.