What Is Inflation and How Does It Work?

Inflation is the increase in the average price of goods and services over time. When inflation rises, each dollar buys less than it did before.

For example, if something costs $100 and its price rises by 3%, it would cost $103.

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How Does Inflation Work?

Inflation happens when prices across the economy increase.

It does not mean every product becomes more expensive at the same rate. Grocery prices might rise quickly while electronics stay the same or become cheaper.

Inflation looks at the overall change in consumer prices.

What Causes Inflation?

Several things can push prices higher.

Higher demand

If consumers want more goods and services than businesses can supply, companies may raise prices.

Higher business costs

Businesses may face higher costs for:

• Labour

• Fuel

• Materials

• Rent

• Transportation

Some of those costs can be passed on to customers.

Supply shortages

A shortage of products or raw materials can push prices higher when demand remains strong.

Currency changes

A weaker Canadian dollar can make imported goods more expensive, which can contribute to higher prices in Canada.

How Is Inflation Measured in Canada?

Statistics Canada measures inflation primarily using the Consumer Price Index, or CPI.

The CPI tracks the changing cost of a basket of goods and services Canadians commonly purchase, including:

• Food

• Shelter

• Transportation

• Clothing

• Household expenses

• Recreation

The inflation rate is commonly expressed as the percentage change in the CPI compared with the same period a year earlier.

How Does Inflation Affect Your Money?

Inflation reduces purchasing power.

If your income stays the same while prices rise, you can afford less with the same amount of money.

It can affect everyday expenses such as:

• Groceries

• Rent

• Gas

• Utilities

• Travel

• Insurance

How Does Inflation Affect Savings?

Inflation matters because your savings need to grow fast enough to maintain their purchasing power.

If your savings earn 1% interest while inflation is 3%, your balance may still increase, but the money is losing purchasing power in real terms.

This is one reason the interest rate on a savings account matters.

How Does Inflation Affect Borrowing?

High inflation can lead central banks to raise interest rates.

That can make borrowing more expensive through:

• Mortgages

• Lines of credit

• Personal loans

• Variable-rate debt

At the same time, higher rates can improve the returns available on some savings products.

Is Inflation Always Bad?

No.

Low and stable inflation is considered normal in a functioning economy.

The Bank of Canada aims to keep inflation around 2%, within a target range of 1% to 3%.

The bigger problem is inflation that rises quickly or becomes unpredictable because it makes budgeting and financial planning more difficult.

What Happens When Inflation Goes Down?

Lower inflation does not usually mean prices are falling.

It means prices are increasing more slowly.

For example, if inflation falls from 5% to 2%, prices are still rising. They are simply rising at a slower rate.

A broad decline in prices is called deflation.

Why Does Inflation Matter?

Inflation affects the real value of your income, savings and debt.

Understanding it can help you make better decisions about:

• Saving

• Borrowing

• Budgeting

• Investing

• Negotiating wages

The key idea is simple: inflation measures how quickly prices are rising and therefore how quickly the purchasing power of your money is changing.