Do you ever wonder why some things are way more expensive than they were when you were a kid? It’s a sign of something important in our economy—inflation.
Inflation is a measure of how much prices for goods and services are rising. Lots of factors affect prices—how difficult a product is to find, the cost of labour and the raw materials used to make it, and competition among the places selling it, to name a few. Policies that stimulate economic growth can cause inflation, too: when people have more money, their demand for products and services can rise, and that can pull up prices.
Inflation measures the big picture
To measure inflation every month, Statistics Canada tracks the prices for a long list—what it calls a representative “basket”—of goods and services. The contents of the basket reflect how much Canadians typically buy of each good or service. The prices of these items add up to a measure of average prices, known as the consumer price index, or CPI.
Each one of us has our own experience with inflation, based on what we buy each month. A smoker who drives a car and eats in steakhouses doesn’t face the same inflation as his vegan, non-smoking friend who commutes by bicycle.
Since the CPI is an average measure, it represents the big picture of consumer spending across Canada. It is not the only measure of inflation, but it is the most common one, used by businesses, institutions and governments. For example, the rise in the CPI every year influences the raises many Canadians get in their annual salaries or the increases in their pensions.
If too high or too low, problems arise
The economy works best when inflation is stable and predictable. A company planning its budget for next year makes assumptions about how much the price of its supplies, its rent and its employees’ salaries are going to go up. When these costs rise, companies raise prices as well. High inflation means that prices are climbing quickly and dollars don’t stretch as far. Purchasing power—our ability to buy products and services with the money we have—weakens.
That’s how high and unpredictable inflation hurts an economy: If incomes don’t increase along with the prices of goods, everyone’s purchasing power goes down. People buy less and the economy starts to slow. High inflation can mean that people who have saved for their retirement may find themselves with less money than they expected. Businesses and consumers must spend time and effort trying to protect themselves from the effects of rising costs.
In extreme cases, high inflation is a symptom of an economy that is out of control. For example, Venezuela’s economic troubles have been accompanied by very high inflation rates, more than 2,800 per cent in 2017, according to the International Monetary Fund. At that rate the $2 cup of coffee you picked up on the way to work would cost $58 a year from now. Such very high rates of inflation are what economists call hyperinflation.
So, if high inflation is bad, deflation—where prices are falling—must be good, right? Not necessarily. A drop in some prices can boost demand for those items. But a general, persistent fall in prices is usually a symptom of deep problems in an economy. When people lose their jobs, they spend less. When firms experience diminishing sales, they lower prices. People may postpone major purchases because they think prices will continue to fall. As more money is saved, less money is spent, prices fall further, and economic activity shrinks.
Inflation over time
Canadians usually don’t pay much attention to inflation. That’s because inflation in Canada has been close to 2 per cent per year for the past 25 years or so.
On average, throughout the 1970s, prices increased by about 8 per cent per year. At that rate, it would take only 9 years for prices to double. When inflation is around 2 per cent per year, it takes about 35 years for prices to double.
In 1991, the Government of Canada and the Bank of Canada agreed it would be good for Canadians to have low, stable and predictable inflation. Their agreement made the Bank responsible for bringing inflation down to about 2 per cent and then keeping it within 1 to 3 per cent. The Bank has been successful in keeping inflation close to 2 per cent.
Low, stable and predictable
To achieve the inflation target, the Bank adjusts (raises or lowers) its key policy interest rate. If inflation is above the 2 per cent target, the Bank may raise the policy rate. This prompts banks to increase interest rates on their deposits, loans and mortgages. Higher interest rates encourage saving and discourage borrowing and, in turn, spending. In response, companies increase their prices more slowly or even lower them to encourage demand. This reduces inflation. Lower interest rates work in the opposite way and can help increase inflation if it is too low.
Of course, the Bank doesn’t respond to every movement in inflation or focus on prices that jump around a lot. Nor does it pay attention to one-time changes in price levels, such as those caused by a new sales tax rate. The Bank focuses on price changes that are more widespread and persistent—ones that could push inflation away from the target for a while. This is because any changes the Bank makes to the policy interest rate will take time to affect people’s spending.
The magic of inflation targeting is that it works best when people’s behaviour reinforces the inflation target. If people expect that prices will rise, on average, by about 2 per cent each year, employers and workers are more likely to agree to a 2 per cent wage increase to compensate for the higher cost of living. And since wages affect the cost of producing goods and services, and the cost affects their prices, this cycle helps the Bank keep inflation on target.