So the oil crisis is a negative shock not only for the Australian economy, but for the global economy as a whole. Higher oil prices lead to higher petrol prices in Australia. Now you need petrol essentially to deliver goods and services to consumers in the economy. The problem we're having now is essentially these oil price increases are coming at a time when inflation in the economy is already higher than where we would like it to be.

So the key challenge facing the Australian economy is inflation. Inflation's been higher than expected for longer than expected. And higher inflation essentially means your income can buy fewer and fewer goods and services, and this leads to a decline in living standards over the next few months. If oil prices continue to rise, essentially, Australians should expect higher inflation. And we're going to start hearing lots more terms about inflationary pressures and cost of living pressures as well.

How the government and the central bank deals with that is also going to be important too. Policy mistakes can actually lead a temporary crisis to become more prolonged. And if you have a more prolonged crisis, essentially the government and the central bank lose control of inflation expectations. And once you lose control of inflation expectations, well, if you're a consumer, you expect prices to start rising rapidly in the future. It's in your incentive to start consuming more today. So you're going to start hoarding, you're going to start buying more today, and that's going to lead to even greater inflation. Now, if you're a business and you expect that consumers aren't going to buy in the future because they expect inflation to be higher in the future, then you're not going to want to produce in the future, and that's going to lead to even more unemployment in the future. So the key is to make sure that inflation remains contained and that consumers know that inflation will remain contained.

So stagflation refers to rising inflation, unemployment and slowing output growth. Now, stagflation is an uncomfortable position for the economy to be in. These are three things that typically don't go together. Usually when economic growth is strong, we have high inflation, or when economic growth is weak, we have low inflation. Stagflation breaks the link between all these variables, and that's why it's high to deal with.

Now the media has started talking about stagflation because high oil prices tend to be associated with stagflation. So when you have stagflation, the government faces a trade off between controlling unemployment or controlling inflation. Any policies that reduce unemployment are going to increase inflation. Any policies that reduce inflation will increase unemployment. And what we know from history is that the government should prioritise reducing inflation. And so that typically would involve something like increasing interest rates. They're going to increase interest rates when households are already facing cost of living pressures. But we know from history that this short term pain is necessary in order to avoid longer term increases in unemployment in the future.