What causes inflation and why does the RBA target it?
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
WACE Year 12 Economics Unit 4 on inflation: measuring it with the Consumer Price Index, the difference between demand-pull and cost-push inflation, the costs of high and unstable inflation, and why the RBA targets 2 to 3 percent.
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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.