How is inflation calculated?

Inflation is a financial term you’ve probably heard bandied about, usually with negative connotations. It generally means the price of goods and services are going up, but how is it calculated?

Inflation has been dominating the headlines in recent times. Economies the world over, including here in Australia, are in the grips of inflation due to two years of a global pandemic followed by a large-scale military conflict.

The news tells you higher inflation means higher prices everywhere – at the supermarket, the petrol station, going out for dinner or having a drink at the pub.

But how is inflation calculated? Do all products and services rise at the same rate? What products, in particular, do economists use to calculate inflation?

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According to the Reserve Bank of Australia, the most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.

In Australia, the CPI is calculated by the Australian Bureau of Statistics (ABS) and published once a quarter.

To calculate the CPI, the ABS collects price data from a range of sources such as retail outlets and government agencies. The CPI is a weighted average of these prices, which are then split into 87 different categories including takeaway food, domestic travel or men’s and women’s clothing.

Some of this price data is collected in person by ABS staff, but today most of it is collected through electronic means such as supermarket scanner data.

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So what kinds of products does the ABS take into consideration?

By far the two largest items in the CPI are rent and the cost of building a new house. Together they account for almost 15 per cent of the total CPI value. Crucially, the CPI doesn’t take house sale prices into account, only the cost of building.

The supermarket is another key CPI area. Virtually everything you would normally find in a supermarket – from fresh fruit and vegetables to paper picnic plates – is measured in the index.

The price of everyday services such as hairdressers, childcare, doctors and hospitals, restaurants and tradespeople are also included. Indexes on particular services can act as smaller, more localised versions of the CPI as the price of the service is directly influenced by the price of any stock the business needs to perform the service.

What is the cause of the price rise?

There is no single factor that causes the price of individual products or services to rise, rather it is due to a combination of reasons. Inflation tends to rise when the economy is strong, and unemployment is low.

When unemployment is low, businesses are forced to increase wages to attract and retain workers, which in turn gives workers more purchasing power. This increases demand for goods and services, which then drives up prices. Business may also increase prices to cover the cost of the increased wages.

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The CPI, and inflation, are also heavily influenced by outside factors.

In the past two years, restrictions caused by the COVID-19 pandemic have wreaked havoc on global supply chains, affecting the supply of virtually all goods, which pushed prices to record highs.

In 2022, Russia’s invasion of Ukraine has drastically cut the world’s supply of oil, putting immense pressure on petrol prices. As goods (and often services) involve transporting items in vehicles that need fuel, these costs are then passed on to the consumer.

Like all parts of the economy, inflation and the CPI are influenced by, and have an influence on, many different parts of life.

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Written by Brad Lockyer