Inflation

Inflation is the rate at which the general level of prices for goods and services rises, eroding the purchasing power of a currency over time. In other words, as inflation increases, each unit of currency buys fewer goods and services. Inflation is a crucial economic indicator, reflecting the health of an economy and influencing financial decisions at both the individual and institutional levels.

Causes of inflation

Several factors can lead to inflation, including:

• Demand-pull inflation: This occurs when the demand for goods and services exceeds supply, driving up prices. It often happens in a growing economy where consumers and businesses are spending more.
• Cost-push inflation: This type of inflation arises when the costs of production increase, leading businesses to raise prices to maintain profit margins. Common causes include rising wages, higher raw material costs, and increased taxes.
• Built-in inflation: Also known as wage-price inflation, this occurs when workers demand higher wages to keep up with rising living costs, which in turn leads businesses to increase prices, creating a feedback loop.
• Monetary inflation: This occurs when there is an increase in the money supply in an economy, often due to central banks printing more money or lowering interest rates. More money in circulation can lead to higher spending and, consequently, higher prices.

Measuring inflation

Inflation is typically measured using indices that track the prices of a basket of goods and services over time. The most commonly used indices in Australia include:

• Consumer Price Index (CPI): The CPI measures the average change in prices paid by consumers for a basket of goods and services, including housing, food, transportation, and healthcare.
• Producer Price Index (PPI): The PPI measures the average change in prices received by domestic producers for their output. It is often seen as an early indicator of inflation, as increases in production costs can lead to higher consumer prices.

Effects of inflation

Reduced purchasing power

As inflation rises, the value of money decreases, meaning consumers can buy less with the same amount of money. This can lead to a decline in the standard of living, especially if wages do not keep pace with inflation.

Impact on savings

Inflation erodes the real value of savings. For example, if the inflation rate is higher than the interest rate on a savings account, the purchasing power of the saved money decreases over time.

Interest rates and borrowing

Central banks, such as the Reserve Bank of Australia (RBA), often raise interest rates to combat high inflation. Higher interest rates increase the cost of borrowing, which can slow down consumer spending and investment, potentially leading to slower economic growth.

Impact on investments

Inflation can have mixed effects on investments. For instance, while inflation may erode the real returns on fixed-income investments, such as bonds, it can benefit real assets like property, which may appreciate in value during inflationary periods.

Managing inflation

Monetary policy

Central banks use monetary policy to manage inflation. The RBA, for example, may adjust the cash rate (interest rate) to influence economic activity. Raising interest rates can help cool down an overheating economy, while lowering rates can stimulate spending and investment.

Fiscal policy

Governments can also use fiscal policy, such as adjusting tax rates or government spending, to influence inflation. For example, increasing taxes or cutting government spending can reduce demand in the economy, helping to control inflation.

Inflation in action

Inflation in action: The impact of inflation on housing affordability

In recent years, rising inflation in Australia has significantly impacted housing affordability. As construction costs and interest rates have increased, so too have property prices and mortgage repayments. This has made it more challenging for first-time buyers to enter the market and has increased the financial burden on existing homeowners. Understanding inflation’s impact on the housing market is crucial for making informed decisions about property investment and home ownership.

Learn more

Financial confidence comes with learning. Explore our Learning Centre and read these helpful links:

• Tips for aspiring property investors
• A guide to building loans for renovators

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Inflation impacts various aspects of financial planning, from savings and investments to loans and property purchases. At Funding, we provide tailored financial solutions to help you navigate inflationary pressures and achieve your financial goals.

Explore how Funding’s business loans and building loans can help you manage the effects of inflation and secure your financial future.