The difference between the price level and inflation

Price levels are a measure of the average cost of goods and services in the economy at a particular point in time. Inflation measures the rate of change in prices over a specific period.

Why we measure both the price level and inflation

The price level and inflation are closely related concepts, but they are not the same thing. In Canada, both the price level and inflation are measured using the consumer price index, or CPI. Statistics Canada publishes the CPI to track the prices of a virtual shopping basket of goods and services. This basket represents the typical purchases that most Canadian households make, including food, shelter, clothing, haircuts and other common goods and services. Every month, the CPI calculates the total price of this basket.

• The result of the calculation is the price level—the average price of goods and services throughout the economy that month.
• Inflation measures the change in prices by comparing the current price level of the basket of goods and services to the price level one year ago. The percentage change is the rate of inflation.

Prices and wages both increase over time

When inflation is high, the price level rises quickly. And when inflation is low, the price level rises more slowly—but it still rises. Even if inflation is only 1%, it means the price level has increased 1% from the year before. And each increase in the price level builds upon the previous one.

Prices are not the only thing that increase over time. Wages also rise—and higher wages can help people manage higher prices. But wages don’t always increase as quickly as the price level does, and when they don’t, consumers feel the pain. Purchasing the same set of goods and services at higher prices takes a bigger chunk out of a worker’s pay. When wages rise as fast as the price level does, a worker’s paycheck grows fast enough to offset the increase in prices.

What inflation, deflation and disinflation mean for the price level

The Bank of Canada targets an inflation rate of 2%. When inflation is at or around that target, this provides stability for households, workers, businesses and the economy as a whole. The price level still rises a little bit each year, but the increases are small enough that most people can manage them. But inflation isn’t always at 2%. Sometimes, the rate of inflation decreases but the price level itself does not fall. This is called disinflation. During times of disinflation, the price level still rises but more slowly than it did before.

At other times, however, the price level does actually fall, and that’s called deflation. When this happens, the rate of change in the price level is negative. A lower price level might sound like a good thing, but deflation can create serious problems for the economy. Many things can happen when the overall price level falls, including:

• Consumers could delay buying some items because they believe they will be able to get a better deal later on. This delay reduces the current demand for goods and services and slows the economy.
• Unemployment can rise. When there is less demand in the economy, companies produce less. Employers hire fewer workers, and some businesses might even lay people off. This leads to higher levels of unemployment that further weakens demand, which can slow the economy even more.

Deflation can therefore cause worse economic outcomes for everyone, which is something we want to avoid. Even when inflation jumps sharply—as it did after the Covid-19 pandemic—our job is to slow the rate of increase to around 2%, not to reverse earlier jumps in prices.

Small increases to the price level each year are normal. But when inflation is not close enough to the 2% target, the Bank can bring it back by adjusting its policy interest rate:

• When inflation is above 2%, the Bank can raise the policy interest rate. This causes disinflation and brings inflation back down toward the target.
• When inflation is below 2%, the Bank can lower the policy interest rate. This stimulates economic activity, which brings inflation back up toward the target.

Raising or lowering the policy interest rate helps us keep the rate of change of the price level—inflation—close to 2%. Inflation that is low, stable and predictable allows households and businesses to plan with confidence, and when they can do that, the economy works better for everyone.