We’ve all felt it – the steady increase in the cost of everyday items. Not so long ago, $100 could fill the grocery cart with all the essentials and maybe even splurge on a few luxuries. Today that same $100 doesn’t stretch nearly as far.

Inflation is one of the key factors driving these changes. You may have heard the term thrown around in news reports or financial discussions, but what does it really mean? And more importantly, how does it impact your wallet?

Below you will find the connection between inflation and the cost of living.

What is meant by cost of living?

In a nutshell, cost of living is the amount of money needed to cover basic expenses such as housing, food, taxes and healthcare.

It can vary greatly from one location to another. For instance, living in a bustling city like Melbourne might be significantly more expensive than residing in a smaller town or rural area.

How is the cost of living measured?

Just because the goods are expensive in an area doesn’t necessarily mean the cost of living is high. The “highness” or “lowness” of the cost of living depends on various factors, including your income and how it compares to the cost of goods and services.

In Australia, experts measure the cost of living in two main ways: the Consumer Price Index (CPI) and the Selected Living Cost Indexes (SLCIs).  They also consider the Wage Price Index (WPI), which measures the change in the price of labour in the market over time.

Here’s how these work together:

Consumer Price Index (CPI)

The Consumer Price Index measurement tracks the changes in the retail prices of a ‘basket’ of goods and services that households typically purchase. These goods and services are grouped into these categories:

• Food and non-alcoholic beverages
• Alcohol and tobacco
• Clothing and footwear
• Housing
• Furnishings, household equipment and services
• Health
• Transport
• Communication
• Recreation and culture
• Education
• Insurance and financial services

These groups are then divided into expenditure subclasses, such as automotive fuel under transport and beef and veal under food and non-alcoholic beverages.

If the price of the items in the basket increases, then the cost of living increases. But still, it’s not enough to say the cost of living is high. This is where the following measurement comes in.

Selected Living Cost Indexes (SLCIs)

Selected Living Cost Indexes measure the impact of changes in CPI within distinct household types.  These might include:

• Employee households
• Age pensioner households
• Other government transfer recipient households
• Self-funded retiree households

SLCIs also consider how each type of household spends its money. For example, older people might spend more on healthcare, while families with children might spend more on education.

Note that not all items or services increase in price at the same rate. For example, the cost of utilities like electricity has gone up a lot in the past ten years. But because utilities don’t make up a large part of most people’s spending (based on SLCIs), the overall cost of living hasn’t increased as much as you might think from the rise in utility costs alone.

Also, different types of households feel changes in the cost of living differently. For example, families that depend on government benefits have seen their prices increase more than households with working people.

In short, while some things have gotten more expensive over the years, these increases have been balanced out by other items that have gotten cheaper or stayed the same price. So although the overall cost of living has gone up, it’s not as much as the price of some individual items might suggest. This means it’s not enough to say the cost of living is high.

Wage Price Index (WPI)

For an accurate evaluation of the cost of living, experts also consider price increases in relation to household income. This is where the Wage Price Index comes in.

The WPI measures the change in the price of labour in the market over time. If wages are not increasing at the same rate as the CPI, it means that people’s income is not keeping up with the cost of living, which can lead to a decrease in living standards. Then we can say that cost of living is “high”.

What is inflation?

It is an economic term that means you’re seeing a gradual price increase over time.

Here’s a simplified version of how the inflation rate is calculated:

• Choose a base year. This is a reference point against which changes in prices are measured. The CPI in the base year is usually set to 100.
• Select a basket of goods and services
• Find the cost of the basket in the base year and current year
• Calculate the CPI for each year by dividing the cost of the basket in that year by the cost of the basket in the base year and then multiplying the result by 100.
• Calculate the inflation rate. Subtract the base year’s CPI from the current year’s CPI, divide the result by the CPI of the base year, and then multiply by 100 to get a percentage.

Formula for Calculating Inflation Rate

The formula for calculating inflation rate is:

• Inflation Rate = [(CPI_Current Year – CPI_Base Year) / CPI_Base Year] * 100

Let’s say we have chosen 2020 as our base year, and we are interested in calculating the inflation rate for 2023.

Our basket of goods and services cost $1,000 in 2020. In 2023, the same basket of goods and services costs $1,050.

First, we calculate the Consumer Price Index (CPI) for each year.

• For 2020 (the base year), the CPI is ($1,000 / $1,000) * 100 = 100.
• For 2023, the CPI is ($1,050 / $1,000) * 100 = 105.

Next, we calculate the inflation rate using the formula:

• Inflation Rate = [(CPI_Current Year – CPI_Base Year) / CPI_Base Year] * 100

Substituting the values we have:

• Inflation Rate = [(105 – 100) / 100] * 100 = 5%

So, the inflation rate from 2020 to 2023 in this example is 5%. This means that the average level of prices increased by 5% over this three-year period.

Causes of inflation

Demand-pull inflation

Demand-pull inflation occurs when the demand for goods and services exceeds the supply. It can be triggered by increased income, a growing population or heightened government spending. When more people want to buy the same amount of goods, sellers can raise their prices, leading to inflation.

Cost-push inflation

Cost-push inflation happens when the costs of production increase, causing producers to raise prices to maintain their profit margins. The causes include rising wages, higher raw material prices or increased taxes. These increased production costs are then passed on to consumers through higher prices for goods and services.

Built-in inflation

Built-in inflation that is already expected to occur in the future. It’s often the result of a cycle where workers demand higher wages to keep up with expected increases in the cost of living. These higher wages increase the costs to businesses, which are then passed onto consumers as an increase in prices, thereby perpetuating the cycle.

How inflation changes the cost of living

When inflation occurs, each unit of currency buys fewer goods and services. This loss of purchasing power impacts the general cost of living for all of us, ultimately leading to a deceleration in economic growth. Here’s how inflation affects these various aspects:

Housing market

As the prices of materials and labour increase, the cost of building new homes goes up, which can push up the prices in the housing market. This can make it more expensive for people looking to buy homes. For renters, landlords may increase rents to keep up with rising costs.

Home sales and mortgage

If inflation is high, it can lead to higher interest rates, which can make mortgages more expensive. This can reduce the number of people who can afford to buy a home, potentially slowing down the housing market. Similarly, if you have a variable-rate mortgage, your mortgage payments could increase. On the other hand, if you’re looking to refinance your mortgage, a period of inflation might lead to higher rates than you were hoping for.

Car and fuel

If the prices of steel and other materials used to make cars go up, this can increase the price of new cars. Similarly, if oil prices go up, this can lead to higher fuel costs.

Food

If the prices of agricultural commodities like wheat and corn go up, the cost of food products that use these ingredients can increase. Similarly, if energy costs go up, this can increase the cost of processing and transporting food, which can also lead to higher food prices.

Utility

Inflation can raise the cost of utilities like electricity, gas, and water. If the cost of producing these utilities rises due to higher energy or labour costs, this can lead to higher utility bills.

Healthcare

If the cost of medical equipment or pharmaceuticals increases, the cost of medical procedures and medications can increase. Similarly, increasing wages in the healthcare sector can also lead to higher healthcare costs.

Need help with debt relief?

If you’re feeling the pinch of rising costs and need help managing your finances, don’t hesitate to reach out to us. We offer a free debt assessment to help you understand your financial situation and provide tailored solutions to manage your debt.

You can also explore our range of debt solutions to find the one that best suits your needs. If you have any questions or need further assistance, please contact us. We’re here to help you navigate these financial challenges and secure a better financial future.