Here’s how inflation works and what can be done about rising prices
Everything seems to get more expensive. Food, gas and housing prices are on the rise, while paychecks are slow to keep pace. CBC News’ Priced Out series explains why you pay more at checkout and how Canadians cope with the high cost of everything.
As the COVID-19 pandemic drags on, high inflation has continued, both in Canada and in Canada. in other parts of the world.
Recent data from Statistics Canada shows that inflation is hovering about five percentwell above the 2% target rate which experts say is the sweet spot.
With the price of everything on the rise, Canadians are increasingly concerned that their bills will increase each month, and businesses are assessing how their costs will evolve in the months ahead.
To help understand all of this, here is a brief explanation of how inflation works and what can be done to curb the rising cost of living.
What is Inflation?
Inflation occurs when the prices of goods and services increase and purchasing power decreases.
When inflation rises, individuals and businesses have to spend more money to buy the same amount of goods and services.
Simply put, everything gets more expensive.
It is important to note that the term “inflation” is reserved for instances where a rise in prices is a sustained trend rather than a fluctuation.
“If it goes up month by month, we say we have inflation,” said David Laidler, professor emeritus of economics at Western University.
Some inflation is still expected in the economy, and the Bank of Canada aims to keep it at around 2%. When the inflation rate deviates from this target or becomes unpredictable, this is when concern sets in among policymakers.
How is inflation calculated?
To measure the rate of inflation, economists in Canada use the Consumer Price Index (CPI). The CPI examines a “basket” of goods and services that roughly represents what the average consumer buys. Statistics Canada updates the contents of this basket every two years to ensure the measure continues to reflect how Canadians spend their money.
WATCH | How Statistics Canada calculates inflation:
Economists will compare the cost of this basket last month with the same month a year earlier. The difference between the two is commonly referred to as the inflation rate.
Suppose an average household spends $100 on chocolate, sweaters and notebooks one month and spends $110 a year later on the same products. In this case, we would say that the inflation rate is 10%.
What causes inflation?
Prices rise when demand in the economy exceeds supply.
There are many theories as to how this can happen, but basically something should trigger a supply disruption or an increase in demand in the economy.
Supply chain issues, such as what has been experienced throughout the pandemic, can cause prices to rise.
In the case of the pandemic, demand for goods and services has rebounded faster than supply, said Dozie Okoye, associate professor of economics at Dalhousie University. As businesses tried to catch up amid a labor shortage and logistical challenges, costs rose.
“Some companies can absorb these costs. Some companies are unable to do so. They have responded by raising prices,” Okoye said.
Inflation can also increase when individuals and businesses have access to more money. Lower interest rates and higher government spending can both increase the money available to people.
When individuals and businesses have more money in their pockets or can borrow at a cheap rate, they are more likely to spend. Low interest rates during the pandemic, for example, encouraged more people to buy homes and take advantage of low mortgage rates.
How does inflation affect people and businesses?
Inflation can eat into people’s budgets, especially without a pay rise.
“If employees are in a position where they can negotiate their wages, you would expect wages to at least keep up with inflation,” Okoye said. “If your salary remains constant and prices increase by 5%, it is as if you were paid less.
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However, what particularly worries economists is unexpected inflation, which disrupts future financial planning.
“You look at the environment around you and you make a plan for the next four or five years. You buy a house, you take out a mortgage,” Laidler said. “Implicit in your decision making is an expectation of what the price level will be.
Without a stable inflation rate, planning for future investments and purchases becomes difficult for both individuals and businesses.
“Once you expect to see one or two percent, it’s built into the contracts. It’s built into the pricing,” Okoye said.
What to do to fight against inflation?
Controlling inflation is the responsibility of a country’s central bank, the institution responsible for managing the money supply. In Canada, the Bank of Canada is legally mandated to “promote the economic and financial well-being of Canada”.
This includes keeping inflation low, stable and predictable.
The Bank of Canada has two tools to maintain its inflation target.
During an economic downturn, the bank may buy government bonds and other financial assets to drive up the price of those assets and thereby reduce the rate of interest that bondholders receive. This tool is called quantitative easing.
Lowering this interest rate influences other interest rates that impact consumers and businesses, making it cheaper to borrow and spend. When the economy is on track and inflation reaches its target, the bank sells the bonds.
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“What they want to try to achieve is to move money through the system through investment or consumption,” Okoye said.
The second tactic is to change the interest rate the bank charges commercial banks, called the overnight target rate. The bank can lower interest rates to stimulate spending. As the economy rebounds, the bank will raise interest rates again to prevent excessive inflation.
For consumers, an increase in interest rates can have an impact on their finances.
“Mortgage rates start to go up. If you have balances left on your credit card, interest rates go up,” Laidler said. “Depending on the state of your household [and] what plans you have made…those interest rate increases have consequences for you.
Okoye says the silver lining is that the Bank of Canada has a reputation for doing what is expected of it.
WATCH | The Bank of Canada explains why it’s not yet ready to raise rates:
In January, the Bank of Canada decided to keep the interest rate on hold, but Governor Tiff Macklem warned that “everyone should expect interest rates to be on an upward trajectory.”
However, Laidler says that having underestimated the duration of inflation, the Bank of Canada has an important task ahead as it seeks to slow it down.
“Now really one of his major tasks is to restore his credibility.”