Inflation

Syllabus: Economic Issues → Inflation.

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What inflation is

Inflation is a sustained increase in the general price level over time. Two words in that definition are doing work. Sustained, because a one-off price rise is not inflation. And general, because a rise in one good's price is a relative price change rather than inflation.

Two related terms need to be precise. Deflation is a sustained fall in the general price level, and it is dangerous because consumers defer purchases while they wait for lower prices, which weakens demand further. Disinflation is a fall in the rate of inflation, where prices are still rising but more slowly. Confusing the two is a standard multiple choice trap and it catches strong students.

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Measurement

The Consumer Price Index

The CPI measures the change in price of a basket of goods and services representative of household spending, weighted by expenditure share.

Inflation rate = ((CPI₂ − CPI₁) ÷ CPI₁) × 100

One change you have to know: since November 2025 the monthly CPI is Australia's headline inflation measure. The ABS still publishes quarterly figures, now calculated as the average of the three monthly indexes. Anything written before late 2025 treats the quarterly series as primary, which dates it immediately.

Headline against underlying

Headline inflation is the change in the whole basket. It is what households actually experience, but it carries volatile items such as fuel and fresh produce, plus one-off policy effects like electricity rebates.

Underlying inflation strips that volatility out to show the persistent trend. The main measure is the trimmed mean, which removes the most volatile 30% of price movements each period.

The RBA targets underlying inflation for a specific reason worth stating. Monetary policy operates with a 12 to 18 month lag, so responding to a temporary petrol price spike would mean responding to something already reversed by the time the policy took effect. Underlying inflation is the better guide to where inflation is actually heading.

The RBA's target

Two to three per cent, on average, over time. Each part of that phrasing is deliberate. A band rather than a point allows for measurement error and shocks. "On average over time" lets inflation sit outside the band temporarily without forcing a destabilising response. And the target is not zero, because a small positive rate buffers against deflation and lets real wages adjust downwards without nominal wage cuts.

Measure	Year to June 2026
Headline CPI	3.8%
Trimmed mean CPI	3.6%
Target band	2 to 3%

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Trends

The recent sequence is your case study for the entire topic, so learn it in order.

Inflation surged after the pandemic, peaking well above the band, and the RBA tightened aggressively from May 2022. It moderated through 2024 and 2025, and the Bank cut three times during 2025, taking the cash rate down to 3.60%.

Then in early 2026 conflict in the Middle East pushed fuel prices sharply higher and headline inflation spiked to 4.6% over the year to March. The Monetary Policy Board judged that the shock was producing second-round effects on top of existing capacity pressure, and raised the cash rate at three consecutive meetings in February, March and May, back to 4.35%.

Headline inflation has since eased to 3.8%. Trimmed mean inflation has gone the other way, rising from 3.3% in March to 3.6% in June.

That divergence is the most sophisticated point available in this topic and very few candidates use it. The fuel spike is washing out of the headline number while the underlying pressure it created has not. That is what second-round effects look like in the data, and it is why the RBA is not treating the shock as temporary.

The Bank's May 2026 forecasts do not have inflation back at the midpoint of the band until mid-2028.

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Causes of inflation

Demand-pull inflation

Aggregate demand grows faster than aggregate supply can accommodate. With the economy at or near capacity, excess demand bids up prices instead of calling forth more output:

AD ↑ beyond productive capacity → excess demand → firms raise prices → inflation ↑

It comes from strong consumption or investment, expansionary fiscal or monetary policy, a booming export sector, or high consumer confidence.

Contractionary macroeconomic policy is the response. This is the type demand management can address head-on, which is why identifying it correctly matters so much.

Cost-push inflation

Production costs rise and firms pass them into prices to protect margins:

input costs ↑ → aggregate supply ↓ → prices ↑ and output ↓

It comes from wages rising faster than productivity, higher oil and energy prices, higher raw material costs, supply chain disruption, or increased indirect taxes.

This is the hardest type to deal with, and explaining why is where the evaluation marks are. Cost-push inflation raises prices and reduces output at the same time, which is stagflation. Contractionary policy can lower the inflation only by reducing demand further, deepening the output loss. Monetary policy finds itself as a demand-side instrument confronting a supply-side problem.

Australia in 2026 is exactly that case. The trigger was a global fuel price shock. The RBA is not tightening because demand is booming. It is tightening to stop a supply shock becoming embedded, and paying for it in falling real wages and per-capita output growth of just 1.0%.

Imported inflation

A subset of cost-push, arising from higher prices for imported goods and inputs, and it has two sources. A depreciation of the AUD raises the Australian dollar price of every import. Higher world prices do the same thing regardless of what the exchange rate does.

Fuel is the critical channel, because it is priced in US dollars and feeds into almost everything else through transport costs. With the AUD around US$0.70, this channel is live.

Inflationary expectations

If people expect inflation, they behave in ways that produce it. Workers bargain for higher wages to protect real income, and firms raise prices pre-emptively against costs they expect to face. Inflation becomes self-fulfilling:

prices ↑ → workers demand higher wages → firms' costs ↑ → firms raise prices → prices ↑ …

This is the single most important concept for understanding what the RBA is doing. Expectations are why a central bank must respond to a supply shock it cannot fix at source. If a temporary shock gets embedded in expectations it becomes permanent inflation, and unwinding it later takes a far deeper recession than acting now. Anchoring expectations is the Bank's real objective in 2026, and saying so is what separates a top-band answer from a competent one.

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Positive and negative effects

Negative effects of high inflation

Real income and purchasing power erode, and the damage falls hardest on those with fixed nominal incomes, such as pensioners and workers without indexed wages. With wages growing 3.3% to the March quarter 2026 against headline inflation of 4.6%, real wages fell by roughly 1.3 percentage points.

International competitiveness suffers. If Australian inflation runs above our trading partners', our exports become relatively more expensive and the balance on goods and services worsens.

Investment decisions get distorted. Uncertainty about future prices shortens business planning horizons and pushes funds into speculative assets such as property and commodities rather than productive investment.

Wealth is redistributed from lenders to borrowers, because debts are repaid in less valuable dollars, and savers holding cash are penalised.

Interest rates rise as the central bank responds, raising borrowing costs and slowing growth. That is the cost Australia is paying right now.

Bracket creep pushes taxpayers into higher brackets on nominal wage rises with no increase in real income, which is an unlegislated tax increase. And there are menu and shoe-leather costs, meaning the resource cost of constant repricing and of managing cash holdings.

Positive effects of low and stable inflation

Read this dot point carefully, because the benefits attach to low, stable, predictable inflation rather than to high inflation. Answering otherwise reads as though you think high inflation is a good thing.

Low positive inflation avoids deflation, which is the more damaging condition because it encourages deferred consumption. It allows real wages to fall without the nominal wage cuts workers resist so strongly, which greases labour market adjustment. It erodes the real value of debt, which benefits borrowers including governments. Mild inflation often accompanies strong demand, high employment and rising output. And it encourages spending and investment rather than hoarding cash.

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What the exam does with this

Inflation carried Section IV in 2022, on the effects of inflation on individuals, firms and government, and it appears in Section II most years.

Five things to get right.

Identify which type of inflation the question describes. The policy prescription depends entirely on it, and prescribing contractionary policy against cost-push inflation without acknowledging the stagflation problem is a weak answer.

Use the headline and underlying distinction with the current numbers. Headline at 3.8% against a trimmed mean of 3.6% and rising is genuinely rich evidence.

Bring in inflationary expectations, because they explain RBA behaviour better than anything else you can say.

Compute the real wage effect. Nominal wage growth minus inflation takes one line and converts a general claim into evidence.

When a question asks about positive effects, answer about low and stable inflation specifically.

Related notes: Monetary policy · Unemployment · Exchange rates · Australian economy statistics