Inflation is an increase in the general level of prices with an associated decrease in the purchasing power of money. It’s a broad measure used to convey the rate of change in the cost of living in a particular nation or its provinces/states. Negative inflation is more commonly referred to as deflation.
Inflation is an important indicator of economic health. Governments and central banks use inflation data to inform economic policy decisions, based on how closely readings align with official inflation targets.
Headline inflation is separate from core inflation, which excludes the most volatile components — food and energy. Both are important metrics, but official targets are usually for headline inflation.
What causes inflation?
Inflation tends to occur when there is too much money chasing too few goods. Demand-pull inflation is driven by rising demand for goods or services while cost-push inflation occurs when supply shortages lead to higher prices.
Too much money is generally the result of monetary policy decisions where central bankers printed too much money. When the supply of money becomes more abundant, money loses some of its value.
Too few goods will typically be the result of supply constraints. There could be insufficient raw material inputs, labour shortages or issues with shipping being backlogged or blocked that will wreak havoc with supply.
These imbalances on either side of the demand-supply equation are the root causes of inflation.
Inflation expectations, which are a byproduct of actual inflation and a few other factors, are another contributor. Inflation expectations matter because actual inflation depends, in part, on what consumers, business leaders and investors expect the inflation rate to be. Essentially, if people believe their money will lose value, then they will spend it before its value can decline.
In addition, with elevated inflation or inflation expectations, employees will demand wage increases to make up for their diminished purchasing power. When workers secure higher wages, companies in turn raise prices to help offset their own rising costs, which drives up inflation even further.
The effects of inflation
Inflation affects people differently. Consumers uniformly dislike inflation, because nobody wants to pay more for the same goods or services. Savers also dislike inflation since it erodes the value of their savings.
But, someone with debt likely doesn’t mind inflation, as it essentially reduces the amount they owe. When inflation rises, borrowers owe the same amount of money on paper, but have higher nominal* incomes with which to pay off their debt. The nominal amount of debt is the same, but its real* value is lower.
Inflation also reduces lenders’ willingness to loan money. They worry that when loans are repaid, the funds received as repayment will have less purchasing power than those lent out. This uncertainty can have an adverse effect on new businesses and business development activities, which often rely heavily on loans to fund their operations.
*Note: nominal value is the current or face value that does not take inflation into account, while real value is the nominal value after being adjusted for inflation.
Consumer price index (CPI)
The consumer price index, or CPI, is the most common measure of inflation and became the most-watched economic indicator when inflation hit multi-decade highs in 2021. CPI and inflation are used interchangeably: inflation/deflation is the increase/decrease in the general level of prices as denoted by CPI.
CPI is a weighted average of the prices of various goods and services, including primarily; food, shelter, transportation, and household expenses. It’s calculated by tracking price changes for a basket of household goods and services purchased by consumers.
The CPI basket of goods and services is intended to represent the experience of a typical consumer. The component weights are based on usage habits and adjusted every two years in Canada and every five years in the US.
Living with inflation
Inflation is an economic fact of life that highlights the interrelationship between the relative cost of goods and services, and the value of money.
Inflation is always an economic concern – and it became a big one in 2021-22. Economists and central bankers now have a relatively good understanding of what causes inflation and how to go about reducing it, in particular compared to the 20th century, when inflation was far more prevalent.
But whether the economy is in a highly-inflationary period or not, understanding inflation, its causes, and its effects, is important for anyone participating in the economy – which is pretty much everyone.