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How inflation affects your income: Explained

Nicola Chand  |  12 Apr 2022Text size  Decrease  Increase  |  
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Inflation. A financial concept traditionally found in the minutes of Reserve Bank meetings and Treasury papers. But as everyday Australians see prices rising from the petrol pump to the shopping trolley, inflation is on the mind.

In this article, we’ll explain what inflation is and why it’s occurring. Then we’ll look at how it affects your income and how you can calculate your own inflation rate.

What is inflation and why is it happening?

Inflation occurs when the prices of goods and services in an economy increase over time. While prices are always on the move, economists look for and measure general increases in prices. If the local cafe increases the price of a coffee by 2%, this might not be inflation on its own. But, if the coffee shop, the petrol station, and the fruit and veg shop all increase their prices by 2%, it might be inflation.

This general increase in prices happening today is occurring across numerous sectors. Prices rose 3.5% in the December quarter, above the RBA’s inflation target of 2%-3%. This is the highest it’s been since 2011.

In the year to December 2021, the most notable price changes have been in the transport and housing sector, an increase in prices of 12.5% and 4% respectively. The RBA puts this down to “higher dwelling construction costs and automotive fuel prices”. 

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Australia isn’t alone. Price increases are occurring across the globe, with US inflation hitting a 40-year high of 7.9% last month. At this point, it might be easier to name the developed economies that aren’t experiencing rapid inflation.

There are two main reasons for price hikes.

First is supply chain issues. The covid-19 pandemic and Russia’s invasion of Ukraine have created shortages for goods while consumers are demanding more. Put best by American economist Milton Friedman, “inflation is caused by too much money chasing after too few goods”. This is known as demand-pull inflation.

Second is increasing cost of inputs, a dilemma Elon Musk is all too familiar with. The rising cost of raw metals and logistics services used by the electric carmaker forced the Tesla chief to hike car prices in China and the US. This type of inflation is known as cost-push inflation.

I recently got a pay rise. Does that mean I don’t have to worry about inflation?

That depends on how big your pay rise was and if you experienced real wage growth.

Real wage growth is when your pay rises higher than the current rate of inflation, meaning you have increased your purchasing power.

Purchasing power is the number of goods and services that can be purchased with $1.

All else equal inflation and purchasing power have an inverse relationship. This means that if inflation outpaces wages, your purchasing power decreases.

When we say real wage growth means increased purchasing power, it means your pay has increased more than the inflation rate. You can now buy more with your money than you could before.

Inflation is a unique experience

The Australian Bureau of Statistics measures the Consumer Price Index (CPI) from a basket of thousands of goods weighted by how much a typical household spends on them.

This method provides an overall picture of how prices are changing in Australia, but it is important to remember everyone has their own inflation rate.

With many different factors at play such as age, background and occupation, the goods you purchase are sure to differ from other Australians.

For example, Meat and Livestock Australia say that the retail price of meat is up 10% per kilogram in comparison to last year. However, if you are a vegetarian, you wouldn’t have experienced this price increase. Therefore, the weighting of meat products would be reduced to 0% in your personal CPI calculation.

If you ride a bike or can walk to work; the same principle applies to the recent spike in petrol prices.

Different sectors also experience real wage growth at different rates whilst some sectors may not experience real wage growth at all sometimes.

Annual wage growth for a person working in accommodation and food services was +3.5% in the December quarter later year. In line with the inflation rate, it neither added nor took away from their purchasing power.

However, in sectors such as education and training, administrative and support services and mining, annual wage increases lagged inflation and reduced purchasing power.

is a wealth and finance journalist with Morningstar

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