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Published June 25, 2024
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What Is Inflation and How Does it Work?

Inflation is an economic term that describes increases in the price of goods and services over time. Canada's inflation rate recently hit its highest level since 1991.

The cost of goods and services changes over time due in part to something economists call inflation.

In its simplest terms, inflation is the rise of average prices over time. Or, you could think of it as 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, and can cause financial issues if it increases too quickly, particularly for those who don’t experience a corresponding increase in income.

» MORE: How to budget your money

How does inflation work?

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

To continue the fuel cost example from above, Canadian gas prices are hitting record levels right now because of a global surge in demand for crude oil as pandemic-related restrictions on travel, business operations and other economic activity have eased.

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 a 1% to 3% range.

There are various actions the Bank may take to keep the inflation rate as close to that target as possible, like 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 are increasing at a low 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. Low inflation also encourages the creation of new jobs and an increase in higher incomes.

High inflation is a term used when prices increase at a rapid rate. High inflation creates problems for the economy as well as individuals, as a dollar can no longer buy as much as it used to.

High inflation can be especially difficult for retired individuals living on a fixed pension and those with low pay, during times of high inflation, as it decreases the purchasing power of their savings and income. It can also be incredibly tough on small businesses; for example, if their production costs increase and they subsequently need to raise prices on the products they sell, they could lose 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 what it calls the consumer price index (CPI) to measure the rate of inflation in the country.

The CPI tracks price changes for various goods and services, including:

  • Food.
  • Shelter.
  • Household operation expenses.
  • Furnishings and appliances.
  • Clothing, including footwear and jewellery.
  • Transportation.
  • Health and personal care.
  • Recreation, education and sports.
  • Alcoholic beverages, tobacco products, and recreational cannabis.

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

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

In May, Canada’s annual inflation rate rose 2.9%. Inflation has fallen from the 8.1% peak Canadians saw in June 2022, but May’s inflation rate is still above the 2% benchmark targeted by the Bank of Canada.

» MORE: How to save money on groceries

How inflation can impact 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. Because it essentially means each dollar is worth less than it used to be, a sustained high inflation rate can also erode the value of your savings.

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

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