Inflation occurs as prices of goods and services rise, meaning that every dollar you earn will buy less. The purchasing power of your money decreases over time in times of inflation.
If 20 years' ago, a cup of coffee and a slice of cake cost $2 at a cafe and now it costs $7, the increase might be explained by inflation.
If inflation is 2%, a product that cost $1 one year will increase in price to $1.02 the next year.
The Australian Bureau of Statistics (ABS) collects data to measure inflation changes over three-month periods. It creates a “basket” of consumer goods and services purchased by households to track the cost of things such as food, clothing, education, petrol, alcohol, cigarettes, furniture, insurance, holiday travel and accommodation to produce the Consumer Price Index (CPI).
The CPI is the main measure of inflation. The government and economists use the CPI to monitor and evaluate levels of inflation in the Australian economy.
Inflation and the economy
Things such as lower interest rates, a lack of inflation and lower petrol prices can free up cash in the household budget and leave consumers with more money to spend, which can help boost the economy.
If wages increase, consumers might also have more available cash, and businesses and governments can potentially raise the price of goods and services.
The Reserve Bank of Australia (RBA) has a target inflation rate of between 2% and 3%, with a view that this level will keep the economy running smoothly.
Economic activity and inflation both feed into the RBA’s evaluation of the official cash rate at its board meetings throughout the year.
Cutting interest rates can put downward pressure on the Australian dollar, but the policy can also help push property prices higher by encouraging potential buyers to take out mortgages.
When inflation is positive and steady, it can encourage people and businesses to borrow and spend money.
But rapid or excessive inflation can be negative for an economy.
Deflation, or a decline in the prices of goods and services, can also be negative for the economy. It can result in cuts in government or personal spending. Unemployment can increase and with less income, consumers have less money to spend and there is less demand in the economy.
Inflation and you
If your income doesn’t increase at the same pace as inflation, it costs you a greater proportion of your money than before to buy the goods and services you need or want.
Income or investment returns that take the effect of inflation into consideration are known as “real” income or returns.
If your income increased by 3% last year and inflation was 1.7%, then your real income increased by 1.3%.
Inflation and investing
Inflation is one factor that can influence how people invest.
If you are relying on investments to provide an income for you after you retire, those investments have to make at least or more than the current rate of inflation. If your income doesn't earn a greater percentage than inflation, then your retirement income will buy less and it will be more difficult to maintain your standard of living.
Investments such as shares and property have the potential to deliver better rates of return, but they can’t be compared to a savings account or term deposit because they have a higher level of risk.
The value of the money you invest can go down or up. To prevent inflation from reducing the value of your money, investors need to consider a diverse portfolio that includes assets that might reasonably be expected to yield a higher rate than inflation.