An economist talks about inflation and what you need to know about it

One of the most important political and economic issues right now is inflation, but there are a lot of myths about how it is measured, where it comes from, and how it affects the average person.

In June, Canada's inflation rate was 8.1%, the highest it had been in 40 years. Even though there are signs that inflation may be slowing down, many Canadians have dealt with the rising cost of living by spending less, working more to make more money, using their savings, or taking on more debt.

As a professor of economics who studies prices and spending, I'd like to talk about how inflation is measured and how it affects Canadians and the economy as a whole.

How does inflation work?

Inflation is a general rise in prices that makes money worth less because it can't buy as much. Most of us can tell if inflation is high or low by how much things cost. However, the inflation rate that is reported in the news and talked about by policymakers is a specific number made by a small army of statisticians and people who collect data.

The Consumer Price Index (CPI), which is used to track inflation, is made by Statistics Canada in two steps. In the first step, Statistics Canada gets more than a million prices for almost everything that can be bought in the country.

Prices are written down in many different ways, and how often and where they are written down depends on the item. For example, prices for things that change quickly, like food or petrol, or vary from place to place, like rent, are collected more often than prices for things like college tuition or insurance rates, which are only collected once a year.

In the second step, Statistics Canada adds up all of these prices to make the all-item Consumer Price Index. This is done by giving each item's price change a weight based on how much it costs consumers as a whole. These weights are sometimes changed to reflect changes in how people spend their money.

The most recent update in 2021 shows how spending has changed because of the pandemic. For example, the weight for food (15.75%) and transportation (16.16%) is lower, but the weight for shelter is higher (29.67 percent).

Statistics Canada and the Bank of Canada also measure "core inflation." This takes out food and energy, whose prices change the most, from the CPI to give a better idea of long-term price pressures that change less quickly.

What causes prices to go up?

Prices depend on how much people want or need something. When inflation is high, it means that people want more goods and services than they can get.

Strong employment and wage growth, cheap credit, payments from governments related to pandemics, and a shift in demand toward goods consumed at home are all reasons why demand has been high.

The pandemic's effects on Chinese factories, international supply chains, container shipping, trucking, and the Russian invasion of Ukraine, which led to recent price spikes for food and energy around the world, have all hurt supply.

The price level seems higher than it is

Many Canadians think that prices have gone up by more than 8.1% over the past year. Besides criticism of how the CPI is calculated in Canada, there are at least two other reasons.

First, consumer spending is measured by surveys that take into account the different ways people spend money but then combine these differences into a single set of weights that treat every dollar spent the same. Spending habits vary by age, income, location, the number of people in a household, and personal taste, so your budget might not look much like the weights used for the CPI.

Second, we're more likely to notice price changes on things we buy often, and we're more likely to notice price hikes than price drops. Energy and food have had the biggest price increases in the last year. Because of this, we are less likely to notice the (lower) inflation rate for furniture, electronics, education, and health goods that balances these out.

We also pay a lot of attention to rising house prices and interest rates, especially in big cities. However, the cost of owned housing in the CPI is based on historical averages of housing prices (25 years) and interest rates (five years) that show long-term financing costs for the average homeowner, not for someone buying a house today.

What happens when prices go up?

When it comes to inflation, there are people who win and people who lose. It can hurt businesses that end up passing cost increases on to their customers, but it can help others because "everyone else is doing it," so customers won't get mad if they raise their prices.

High wage growth often goes along with high inflation, but not always. People whose wages are not indexed to inflation or below inflation lose out, while those whose wages are indexed to inflation or who can negotiate better wages can gain. People with fixed incomes, such as seniors, often lose money because of inflation, even though many government benefits are adjusted for inflation.

Some asset prices keep up better with inflation than others. The prices of homes, stocks, art and precious metals can go up, but the prices of cash and bonds stay the same.

As long as wages or other asset prices keep up, inflation can make it easier to pay off debts. Inflation can also help the government's finances because taxes can bring in more money than the debt is worth.

Even though it doesn't matter to consumers where inflation comes from, it does matter for economic policy. Central banks and governments must decide if they want to slow down demand and risk a recession by raising interest rates, cutting spending, or raising taxes, or if they want to wait and hope that inflationary pressures on the supply side will go away on their own.

We can only hope that, unlike the last major effort by the Bank of Canada to lower inflation, this period of high inflation will not end with a major recession and that Canada will not experience "stagflation," a combination of high inflation and high unemployment that hurt many economies in the late 1970s.

Adapted from An economist explains: What you need to know about inflation

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