Recently I developed an iPad inflation calculator that uses actual Canadian price data. To supplement the basic functionality, I wrote a handful of short articles about inflation, from a Canadian perspective. I’ll be sharing those articles here and in subsequent posts.
What is inflation?
Money doesn’t have a constant value. A dollar may always equal 100 cents, but your dollar won’t always buy the same amount of goods. Over time, there’s a tendency for the things we buy to rise in price, and each year the same amount of money ends up buying less stuff.
Inflation is the name for this general increase in prices over time, or the reduction in your money’s purchasing power.
Each year, groceries get more expensive. If you drive a car, you’ll notice the price of gas fluctuates, and the long-term trend is up. Pay attention over time to the prices for products and services you use and you’ll see inflation at work.
Inflation is common. All kinds of prices go up, and in many places. Prices have been rising for a long time. In Canada, general price inflation has been present in the economy every year since 1939. Certain periods since have even had high inflation, although inflation has been more tame recently. Yet, inflation’s effects are cumulative and persistent.
Where does inflation come from?
Before the twentieth century, paper money was typically backed by gold (and sometimes silver) under a system known as the gold standard. Under the gold standard, each dollar was convertible to a specific amount of gold. This system tended to have an advantage in long-term price stability, but it also had significant disadvantages. Notably, governments had inadequate control over the money supply, which presented challenges to managing an economy. Countries eventually moved away from the gold standard.
Most governments today, including Canada’s, have currencies that are described as fiat money. Fiat money has no specific intrinsic value or objective standard — although many governments still maintain strategic gold reserves. Fiat money’s value originates from government regulation declaring the currency legal tender, and the public’s willingness to use it as a medium of exchange in the economy. With fiat money, inflation can arise when the money supply expands faster than growth in the overall economy.
Governments aim to manage the money supply, and inflation, through central banks. A central bank is the public institution in charge of managing a country’s currency and money supply, using tools such as setting key policy interest rates, and acting as lender of last resort to regular banks. In Canada, the central bank is the Bank of Canada. The U.S. has the Federal Reserve.
Governments and central banks wish to avoid deflation. Deflation is when the inflation rate is negative and prices are dropping. Many economists regard deflation as a serious threat to the health of an economy. Deflation can deepen economic recessions. Thus, major central banks of the world accept some inflation and even aim for set levels, versus risking any deflation.
The next post looks at why Canadians should care about inflation, and the possibility for future inflation in Canada.