What Is Inflation and Why Does It Happen?

Ever noticed that your favourite coffee or groceries cost more than they did a year ago?

That slow, steady increase in prices is called inflation — and it affects everything from your daily expenses to how far your savings will stretch.

But what exactly is inflation, and why does it happen?

In this article, we’ll break down what inflation really means, what causes it, how it affects your wallet, and what you can do to be better prepared

Understanding Inflation in Simple Terms

Let’s start with the basics.

Inflation is the rate at which the general price level of goods and services rises over time. When inflation goes up, your money buys less than it did before. Let’s say, for instance, your favourite takeaway burger cost $5 last year, but now it costs $5.50 — that extra 50 cents reflects the impact of inflation.

A little inflation is normal — and even considered healthy — for an economy. But when prices rise too quickly (or fall, in the case of deflation), it can cause problems.

How Is Inflation Measured?

In most countries, inflation is measured using a tool called the Consumer Price Index (CPI). This index tracks the prices of a basket of commonly purchased goods and services — like food, fuel, clothing, and rent.

In Australia, the CPI is compiled by the Australian Bureau of Statistics (ABS), and it’s one of the key indicators used by the government and economists to monitor inflation trends and guide economic policy decisions.

Types of Inflation: Not All Are Created Equal

Did you know there’s more than one kind of inflation? Let’s take a closer look at the main types:

Demand-Pull Inflation

This happens when demand for goods and services outpaces supply. Think of it like this: when everyone rushes to buy the latest gaming console — it sells out, and prices go up because of the high demand.

Cost-Push Inflation

This type of inflation occurs when the cost of producing goods increases. For example, if the price of fuel rises, transportation becomes more expensive, and that cost gets passed on to consumers.

Built-In Inflation (Wage-Price Spiral)

This one’s a cycle. Workers demand higher wages due to rising living costs, and companies raise prices to cover wage increases, leading to — you guessed it — more inflation.

What Causes Inflation?

Let’s explore the root causes in more detail. Several factors can lead to inflation, and sometimes they work together.

Increased Consumer Demand

When people are spending more, businesses raise prices to keep up with the demand. This often happens when the economy is strong and unemployment is low, as consumers feel more confident about their financial situation.

Rising Production Costs

If raw materials — like fuel, steel, or wheat — become more expensive, companies have to spend more to make their products, which often leads to higher prices for consumers.

Supply Chain Issues

Natural disasters, pandemics, or international conflicts can disrupt the flow of goods. When supply is limited but demand remains steady, prices tend to rise.

Government Policies and Stimulus

Governments sometimes print more money or distribute financial stimulus packages. While this can help people in the short term, too much money in circulation can reduce the currency’s value and cause inflation.

How Inflation Affects You

Inflation may sound like an abstract concept, but it has very real effects on your everyday life:

Your Grocery Bill Goes Up

This is probably where most people first notice inflation. Essentials like milk, eggs and bread get more expensive, and your weekly shop costs more than it used to.

Your Savings Lose Value

If your money is just sitting in a regular savings account with little or no interest, its purchasing power decreases over time due to inflation.

Loans and Interest Rates Fluctuate

To fight inflation, banks often raise interest rates. That means loans, credit cards and mortgages may become more expensive.

Investment Markets React

Stock markets may become more volatile during inflationary periods, while assets like gold, property or even inflation-linked bonds often become more attractive to investors.

Is Inflation Always Bad?

Some inflation is actually a sign of a healthy economy.

A moderate rate of inflation encourages spending and investment instead of hoarding money. Businesses grow, jobs are created and wages rise.

Central banks — like the Reserve Bank of Australia (RBA) — typically aim for an annual inflation rate of around 2-3%, which helps balance economic growth with price stability.

Inflation vs. Deflation: Two Sides of the Same Coin

Just as inflation means rising prices, deflation refers to falling prices. That may sound great — who wouldn’t want cheaper stuff? But deflation can be harmful too.

When prices drop, people may delay purchases, expecting prices to fall further. This behaviour can reduce business revenue, trigger job losses and slow down the entire economy.

So while inflation isn’t always welcome, deflation is often seen as a bigger threat to long-term economic health.

How Do Governments Try to Control Inflation?

To keep inflation in check, governments and central banks use several tools:

Raising Interest Rates

When borrowing becomes more expensive, people and businesses tend to spend less, which can help slow inflation. In Australia, this is a key role of the Reserve Bank of Australia (RBA), which adjusts the cash rate to influence economic activity.

Reducing the Money Supply

Central banks may tighten monetary policy by reducing the amount of money flowing into the economy, for example, by selling government securities or restricting bank lending capacity.

Fiscal Policies

Governments can adjust taxes or reduce public spending to cool down an overheated economy. This helps decrease demand and ease inflationary pressure.

How Can You Protect Yourself from Inflation?

While we can’t control inflation directly, there are smart ways to protect your finances:

Invest Wisely

Investing in assets that tend to outpace inflation — like shares, real estate or inflation-indexed bonds — can help preserve and grow your wealth. Consider speaking to a licensed financial adviser to explore options suited to your goals and risk tolerance.

Diversify Your Income

Having multiple income streams — such as freelance work, rental income or side hustles — can provide extra security during inflationary periods.

Adjust Your Budget

Re-evaluate your spending habits and cut back on non-essential expenses. Tracking your expenses using popular budgeting apps, like MoneySmart’s Budget Planner or Pocketbook, can help you stay in control.

Build an Emergency Fund

Inflation can lead to job losses and economic downturns. A solid emergency fund gives you peace of mind during uncertain times — ideally covering three to six months’ worth of essential expenses.

The Role of Expectations

Believe it or not, people’s expectations also influence inflation. If businesses expect higher costs in the near future, they might raise prices preemptively. If workers anticipate rising living expenses, they’ll ask for higher wages.

This is known as “inflation psychology” — and it can sometimes turn inflation into a self-fulfilling prophecy, where expectations alone help drive price increases.

Inflation Is Inevitable, But You’re Not Helpless

Inflation is a natural part of a growing economy. While you can’t stop it, you can learn to understand it, prepare for it and make smarter decisions with your money.

Knowledge truly is power. The more you understand how inflation works, the better equipped you’ll be to protect your financial well-being in the long run.

You’ve just learned the basics of inflation — what it is, why it happens and how to handle it like a pro. Stay alert, keep your finances flexible and be ready for whatever the economy throws your way.