Examine the economic issue of inflation including the measurement of inflation, the difference between headline and underlying inflation, the causes of inflation, and the effects of inflation in Australia

What this dot point is asking

NESA wants you to define inflation, explain how it is measured (CPI, headline vs underlying), identify demand-pull, cost-push and imported causes, and analyse the effects with recent Australian data. Expect a 6 to 8 mark response, often with a Section IV essay option on the 2022-24 inflation episode.

The answer

Inflation defined

Inflation is the sustained increase in the general price level of goods and services in an economy over time.

Deflation is a sustained fall in the general price level (rare in Australia; last occurred in some quarters of 2020).

Disinflation is a slowing in the rate of inflation (positive but falling), which has been the focus of RBA policy since 2023.

Measurement

The ABS produces the Consumer Price Index (CPI) quarterly (cat. no. 6401.0). The CPI tracks the cost of a basket of goods and services bought by metropolitan households, including housing, food, transport, education, health, recreation and other expenditure.

The CPI is reported as a year-on-year rate (most commonly cited) and a quarter-on-quarter rate.

Headline vs underlying inflation

Headline inflation is the full CPI, including volatile items.

Underlying (core) inflation strips out the most volatile items to give a clearer signal of trend pressure. Two key measures:

• Trimmed mean CPI. Removes the most volatile 30 percent of CPI items each quarter (the top 15 percent and bottom 15 percent by price change). The RBA's preferred measure.
• Weighted median CPI. The middle item by price change in the weighted CPI distribution.

The RBA targets headline CPI of 2 to 3 percent on average over the cycle, with trimmed mean used to assess underlying pressure.

The 2022-24 Australian inflation episode

A textbook case of the three causes acting together:

Inflation has fallen from its 2022 peak but the descent toward the 2 to 3 percent target has been slow, particularly on the underlying (trimmed mean) measure.

Causes of inflation

1. Demand-pull inflation. Excess aggregate demand pushes the economy beyond its productive capacity. AD/AS framework: a rightward shift in AD when the economy is at or near LRAS produces inflation.

Australian drivers 2021-22:

• Cash rate at 0.10 percent (lowest in history).
• JobKeeper, JobSeeker supplement, cash flow boost: around $250 billion in stimulus.
• Household savings of $300 billion built up during lockdowns.
• A tight labour market: unemployment to 3.5 percent (50-year low) in 2022.

2. Cost-push inflation. Rising costs of production passed through to prices. AD/AS framework: a leftward shift in SRAS produces inflation and lower output (stagflation in extreme cases).

Australian drivers 2022-24:

• Energy: wholesale electricity prices doubled in 2022 after Russia's invasion of Ukraine disrupted global gas markets.
• Wages: Wage Price Index growth rose from below 2 percent pre-pandemic to 4.2 percent by mid-2024 (ABS).
• Building materials: construction cost inflation peaked above 10 percent year-on-year.

3. Imported inflation. Rising prices of imported goods and services, often driven by exchange rate depreciation or global shocks.

Drivers 2022-24:

• AUD/USD fell from around USD 0.78 (early 2021) to around USD 0.62 (late 2024).
• Global oil and grain prices spiked after Russia's invasion of Ukraine.
• Global container shipping rates rose 5-fold in 2021-22 before normalising.

Other causes

Inflationary expectations. When households and businesses expect future inflation, they negotiate higher wages and set higher prices, validating the expectation. The RBA monitors inflation expectations from union surveys, financial markets and consumer surveys.

Inflation inertia. Wage and price contracts make inflation slow to adjust. Service inflation (40 percent of CPI) is particularly sticky because of long-term contracts and labour-intensive cost structures.

Effects of inflation

Negative effects:

1. Reduced real purchasing power. Money wages must keep pace with prices to maintain living standards. Real wages fell in Australia in 2022 and 2023 as inflation outran the Wage Price Index.

2. Income redistribution. Inflation erodes the real value of fixed nominal incomes (pensioners, fixed-rate creditors) while benefiting those with debt (mortgage holders) and real assets (homeowners).

3. Loss of international competitiveness. Higher Australian inflation than trading partners erodes export competitiveness and worsens the trade balance, unless offset by AUD depreciation.

4. Distortion of investment decisions. High and uncertain inflation discourages long-term investment.

5. Menu costs and shoe-leather costs. Frequent price changes are administratively costly. People hold less cash and more time managing money.

6. Bracket creep. Income tax thresholds are not fully indexed, so inflation pushes taxpayers into higher brackets, raising the effective tax rate.

Positive effects (in moderation):

1. Lubricates the labour market. A small positive inflation rate makes it easier to adjust real wages downward without nominal cuts.

2. Buffer against deflation. A positive target gives monetary policy room before hitting the zero lower bound.

3. Erodes real debt. Borrowers benefit from inflation that erodes the real value of fixed-rate debt.

Inflation and economic policy

The RBA's target is headline CPI of 2 to 3 percent on average. The RBA Statement on Monetary Policy (every quarter) is the canonical source for inflation analysis. The 2022-23 tightening cycle was the fastest in 30 years: the cash rate rose from 0.10 percent to 4.35 percent in 18 months.

Fiscal consolidation also contributes: the 2023-24 federal Budget returned a surplus and tightened the structural position, easing demand pressure.

Supply-side policies (training, productivity-enhancing infrastructure, migration) shift LRAS rightward and reduce inflation pressure long-term.

Common HSC traps

Confusing inflation with the price level

Inflation is the rate of change of the price level.

Treating CPI as a perfect measure

It excludes asset price inflation (housing, equities), under-weights some items (housing services), and assumes a fixed basket.

Ignoring the AS side

Inflation is not just an AD problem. The 2022 inflation surge had major cost-push and imported components, and the policy response combined demand restraint (rate rises) with supply-side measures (migration).