Define and measure inflation using the CPI, distinguish demand-pull from cost-push inflation, and explain the effects of inflation and the rationale for the RBA's inflation target

What this dot point is asking

SCSA wants you to define and measure inflation, distinguish its two main causes, explain its effects, and link it to the RBA's target. Expect a CPI calculation or data-interpretation task plus a short or extended response on causes and effects.

Measuring inflation

The CPI tracks the price of a fixed basket of goods and services bought by a typical metropolitan household, weighted by spending patterns, and is published quarterly by the ABS.

Economists also watch underlying inflation (the trimmed mean), which strips out the most volatile price movements to reveal the persistent trend the RBA targets.

Causes of inflation

Demand-pull inflation

Demand-pull inflation occurs when aggregate demand grows faster than the economy's capacity to supply, especially near full employment. Too much spending chases too few goods, bidding up prices. On the AD/AS model, aggregate demand shifts right along a steep supply curve, raising the price level.

Cost-push inflation

Cost-push inflation occurs when the costs of production rise (wages, imported inputs, energy) and firms pass the increase on as higher prices. On the model, aggregate supply shifts left, raising prices while reducing output, the painful combination known as stagflation.

Effects of inflation

High and unstable inflation imposes real costs:

• Erodes purchasing power, especially for those on fixed incomes and savers.
• Reduces international competitiveness if Australian prices rise faster than competitors'.
• Creates uncertainty, discouraging long-term investment and saving.
• Distorts decisions through bracket creep (inflation pushing incomes into higher tax brackets) and arbitrary redistribution between borrowers and lenders.
• Can become self-reinforcing through a wage-price spiral if expectations rise.

A small, stable, positive inflation rate is preferred to deflation, which can trap an economy in falling prices, deferred spending and rising real debt.

Who wins and who loses from inflation

Inflation redistributes income and wealth in ways that are not chosen by policy. Borrowers with fixed-rate debt gain, because they repay loans in dollars that are worth less than the dollars they borrowed; lenders and savers lose for the same reason. People on fixed nominal incomes (some pensioners, workers on long fixed contracts) lose purchasing power, while those whose incomes are indexed to the CPI are protected. Asset owners often gain because property and shares tend to rise with the price level, while cash holdings fall in real value. This arbitrary redistribution is one reason a stable, predictable inflation rate is valued: it removes the lottery element from saving and borrowing.

Inflation and the rest of the economy

Inflation does not sit in isolation. It interacts with the other macroeconomic objectives in ways the WACE course expects you to link:

• Unemployment. The short-run Phillips relationship suggests a trade-off: policies that lower unemployment by boosting demand can lift inflation, and vice versa. The RBA must balance the two.
• The exchange rate. Higher relative inflation erodes international competitiveness and tends to put downward pressure on the Australian dollar over time.
• External balance. Faster domestic inflation can worsen the balance on goods and services as exports become dearer and imports relatively cheaper.

Because of these links, the RBA's flexible inflation target is framed as inflation of 2 to 3 percent "on average, over time", giving it room to look through temporary shocks and to weigh employment alongside price stability.