Economics provides us with frameworks for examining a wide variety of real life problems and issues, and tools to measure and assess what will happen under different circumstances.

Inflation

Inflation generally refers to the rate of price increases. In practice this refers to the price increase in the consumers price index (CPI), which tracks the prices of a basket of goods and services consumed by the average New Zealander.

 Inflation is important as it can distort incentives to consume, save and invest. If prices are rising rapidly, then it is better to spend money now, rather than save. As a dollar saved today will buy less tomorrow when prices have increased. This can also delay investment, reducing the future growth of the economy. Rapidly falling prices are also a problem, as it then makes sense to delay purchases which will be even cheaper in the future.

This is why the Reserve Bank of New Zealand aims to keep inflation between 1% and 3%. At low levels of inflation the distortions to consumption, saving and investment are small. Periods of low inflation are generally accompanied by relatively stable economic growth.

 How does it affect me?

 Inflation affects how much your money today can buy in the future. Consider the example where you have $1 and an apple costs $0.50. You can buy two apples. Next year the price of apples double to $1, your $1 now only buys one apple, so your purchasing power has fallen. Inflation erodes the value of savings.

Wages need to keep growing to compensate for inflation. Otherwise your wages will support less goods, services and comforts. Prices rise more quickly when demand for goods and services outstrip supply. So inflation tends to be high when the economy is overheating.

The RBNZ will tend to raise interest rates to cool the economy and inflation. Higher interest rates are good for savers, as they will receive more income on their deposits, but bad for borrowers who have to pay more interest on their mortgages.

 

 Conceptual measurement issues

 The CPI is a simple measure to show how much prices are rising on average in the economy. As it is based on total economic spending, it is representative of the whole economy. This is the best indication of how inflation is impacting on firms and households. However, it does not represent the spending behaviour of any individual. Therefore, each person is going to be affected by price rises in a different way to the CPI.

 Further information

Details of the CPI can be found at Statistics New Zealand:  www.stats.govt.nz
For information on how the RBNZ influences inflation, see our section on monetary policy.