Understanding inflation

Inflation is a persistent rise in the average level of prices over time.

Benefits of low inflation

Low, stable and predictable inflation is good for the economy—and for your finances. It helps money keep its value and makes it easier for everyone to plan how, where and when they spend.

For example, companies are more likely to grow their business when they know what their costs will be in the years ahead. This helps the economy expand at a sustainable pace, generating higher incomes and new jobs.

How inflation works

Prices tend to go up when the demand for goods and services is more than the economy supplies.

Prices tend to go down when the economy supplies more goods and services than people want or need.

When prices change so slowly that they don’t affect how people spend, save or invest, the Bank of Canada considers this price stability.

Effects of high inflation

When prices go up, money can’t buy as much as it used to. This loss of purchasing power hurts everyone’s standard of living.

When inflation is high, consumers, businesses and investors are uncertain about what their costs will be from one day to the next. High inflation is often unstable and unpredictable, and that keeps the economy from performing at its best.

High inflation makes life especially hard for people whose incomes don’t keep pace with rising prices, such as pensioners and those with low pay. This is because high inflation decreases the value of their incomes and savings.

Effects of deflation

A persistent decline in the level of prices can also have a negative impact on the economy. This is called deflation. It is usually a sign that something is seriously wrong with the economy. Deflation leads to lower production and wages. This reduces demand from consumers and businesses, which then leads to still lower prices, and so on.

The one major episode of sustained deflation in Canada was in the 1930s, during the Great Depression. A dramatic drop in spending triggered a decline in prices of more than 20 percent over four years.

The rate of inflation

To measure inflation, we look at the consumer price index (CPI) and how quickly it is rising. For example:

  • In one year, the basket of goods and services the CPI uses costs $100.
  • The next year, the same basket costs $102. That means the average annual rate of inflation is 2 percent.

At the Bank, we target a 2 percent inflation rate, the middle of a 1 to 3 percent range. We have agreed with the federal government that this is the best way for us to promote the economic and financial well-being of Canadians.

The words are sometimes confused, but there’s a difference between deflation and disinflation. With disinflation, prices still go up, but they don’t rise as fast. For example, if the rate of inflation is 2 percent one year and 1 percent the next, the economy is experiencing disinflation.

How we focus: core inflation

We don’t respond to every movement in inflation. And we don’t pay attention to one-time changes in price levels, such as those caused by a new sales tax rate. We focus on price changes that are more widespread and persistent—ones that could push inflation away from the target for a while.

To help us figure out which price changes to focus on, we use a concept called “core inflation.” We have three different measures of core inflation. Together, they help us look past the bumps and wiggles of different price changes so that we can see the underlying trend of inflation.

The role of expectations

Inflation targeting plays an important role in ensuring people continue to expect inflation to be around 2 percent. And when people expect inflation to stay under control, they act in a way that tends to bring that about.

People will shrug off short-term changes in prices if they believe inflation will remain low in the long run. Businesses don’t immediately raise their prices, and consumers continue to spend and borrow. Their confidence that inflation will remain low helps keep inflation low by allowing the economy to stabilize after short-term bumps.

Throughout the 1970s, prices increased by an average of about 8 percent per year. At that rate, it would take only 9 years for prices to double. When inflation is around 2 percent per year, it takes about 35 years for prices to double.