What Is Inflation and How Does it Work?

Costs change over time due to what we call "inflation."

Put simply, inflation is the rise of average price levels over time. It can also mean a decrease in the value of money over time.

For example, when you compare the cost of a litre of gas today to what it was 25 or 50 years ago, much of that cost difference can be attributed to inflation.

But inflation affects more than just the price of goods and services; it can cause financial issues if it increases too quickly, particularly for those who don’t experience a corresponding increase in income.

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How does inflation work?

Inflation is largely influenced by supply and demand. Prices tend to go up when there is a higher demand for products or services than the economy can provide. It also works in reverse; when there is less demand for products or services than the economy supplies, costs go down (often referred to as deflation).

To continue the fuel cost example, gas prices in many parts of Canada hit record levels when pandemic restrictions on travel, business operations and other economic activity eased, which led to a global surge in demand for crude oil.

The Bank of Canada monitors various aspects of inflation, paying close attention to the rate and its effect on economic activity.

On its website, the Bank says it targets a 2% inflation rate, the middle of an inflation-control target range of 1% to 3%.

There are various actions the Bank may take to keep the inflation rate as close to that target as possible, including limiting or boosting the amount of money in circulation, or encouraging changes in Canada’s fiscal policies, like debt reduction.

» MORE: How Treasury bills work in Canada

High vs. low inflation

Low inflation is a term economists use when prices increase at a low, predictable and stable rate.

Low inflation is best for the economy because it allows people to plan how and where to spend their money, and helps the Canadian dollar keep its buying power. Generally, low inflation is associated with a better environment for the creation of new jobs and increased incomes.

High inflation is a term used when prices increase at a rapid rate.

This creates problems for the economy as well as individuals as a dollar can no longer buy as much as it used to. High inflation generally creates an uncertain and unpredictable environment that often negatively impacts the economy.

High inflation can be especially difficult for retired individuals living on a fixed pension and those with low pay, as it decreases the purchasing power of their savings and income. It can also be tough on small businesses; for example, if production costs increase and they need to raise their product prices, they risk losing customers.

» MORE: 5 survival strategies for times of high inflation

What is the inflation rate and how is it measured?

The Bank of Canada uses the Consumer Price Index (CPI) to measure the country’s inflation rate.

The CPI tracks price changes for various goods and services in Canada over time. These goods and services are divided into nine categories:

These goods and services are gathered into a “virtual shopping basket,” which is compared over time and averaged to assess, measure, and keep track of inflation across the country.

Inflation is measured monthly and can vary quite a lot — not only year to year, but also month to month.

In April 2025, Canada’s annual inflation rate cooled to 1.7%, down from 2.3% the month prior. This is the first month that headline inflation has fallen below the 2% price growth threshold set by the Bank of Canada since January 2025.

» MORE: How to save money on groceries

How inflation impacts you

A high inflation rate can impact your daily life in both positive and negative ways.

As prices increase, it may be harder to afford things like groceries, rent and post-secondary education. This may lead you to cut back on spending or seek out loans to help cover costs and payments. A sustained high inflation rate can also erode the value of your savings because it essentially means each dollar is worth less than it used to be.

On the other hand, high inflation can be beneficial to certain investors. If you hold any assets in markets seeing price increases, you could potentially enjoy a higher rate of return on those investments.