Here's how inflation works and what can be done about rising prices

Everything seems to be getting more expensive. Food, gas and housing prices are on the rise whilepaychequesare slow to keep pace.TheCBCNews series Priced Out explains why you're paying more at the register and how Canadians are coping with the high cost of everything.

As the COVID-19 pandemic has dragged on, so has high inflation, both in Canada and in other parts of the world.

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Recent Statistics Canada data shows inflation hovering around fiveper cent, well above the two per cent target rate that experts think is the sweet spot.

With the price of everything on the rise, Canadians are increasingly concerned about their bills creeping higher each month, and businesses are gauging where their costs are heading in the months to come.

To help make sense of it all, here's a brief explanation of how inflation works and what can be done to rein in the rising cost of living.

What is inflation?

Inflation is when prices for goods and services rise and purchasing power falls.

When inflation goes up, people and businesses have to spend more money to buy the same amount of goods and services.

Put simply, everything becomes more expensive.

It's important to note that the term "inflation"is reserved for instances where a rise in prices is a sustained trend rather than a fluctuation.

"If it's going up month by month, we say we've got inflation," said David Laidler, professor emeritus of economics at Western University.

Some inflation is always expected in the economy,andthe Bank of Canada aims to keep it at around two per cent. When the inflation rate deviates from this target or becomes unpredictable, that's when worry sets in for policymakers.

How is inflation calculated?

To measure the rate of inflation, economists in Canada use the Consumer Price Index (CPI). The CPI looks at a "basket"of goods and services that roughly represents what the average consumer purchases. Statistics Canada updates what this basket contains every two years so the measure continues to reflect how Canadians are spending their money.

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Economists will compare the cost of this basket last month with the same month a year earlier. The difference between the two is commonly known as the inflation rate.

Let's say the average household spent $100 on chocolate, sweaters, and notebooks one month and spent $110 a year later on the same goods. In this case, we'd say the inflation rate is 10 per cent.

What causes inflation?

Prices rise when demand in the economy outpaces supply.

There are many theories about how this can occur, but fundamentally, something would have to trigger a disruption to supply or a boost in demand in the economy.

Supply chain issues, such as what has been experienced throughout the pandemic, can lead to prices rising.

In the case of the pandemic, demand for goods and services rebounded faster than supply, said Dozie Okoye, an associate economics professor at Dalhousie University. As businesses tried to catch up amid a labour shortage and logistical problems, costs rose.

"Some businesses can absorb those costs.Some businesses aren't able to do so. They responded by increasing prices," said Okoye.

Inflation can also rise when people and businesses have access to more money. Lower interest rates and higher government spending can both increase the money available to people.

When people and businesses have more money in their pockets or can borrow at a cheap rate, they're more likely to spend. Low interest rates during the pandemic, for example, encouraged more people to buy homes and take advantage of low mortgage rates.

How does inflation affect people and businesses?

Inflation can eat away at people's budgets, especially without a pay raise.

"If employees are in a situation where they can negotiate their wages, you'd expect wages to at least keep up with inflation," said Okoye. "If your wage remains constant and prices increase five per cent, then it's as if you're being paid less."

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However, what economists particularly worry about is unexpected inflation, which throws off future financial planning.

"You look at the environment around you and you make a plan over the next four or five years. You buy a house, you take out a mortgage," said Laidler. "Implicit in your decision making is an expectation of what the price level is going to be."

Without a stable inflation rate, planning future investments and purchases becomes difficult for both people and businesses.

"Once you expect to see one or two per cent, it's built into contracts. It's built into prices," said Okoye.

What can be done to combat inflation?

Controlling inflation is the responsibility of a country's central bank the institution responsible for managing money supply. In Canada, the Bank of Canada is legally mandated to "promote the economic and financial welfare of Canada."

This includes maintaining low, stable and predictable inflation.

The Bank of Canada has two tools at its disposal to maintain its target inflation rate.

During an economic downturn, the bank can buygovernment bonds and other financial assets to drive up the price of these assets and thereby lowerthe interest rate bondholders receive. This tool is called quantitative easing.

Lowering this interest rate influences other interest rates that impact consumers and businesses, making it cheaper to borrow and spend. When the economy is on track and inflation reaches its target, the bank sells off the bonds.

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"What they want to try to achieve is to get money flowing through the system through investment or consumption," said Okoye.

The second tactic is changing the interest rate the bank charges commercial banks, called the target overnight rate. The bank can lower interest rates to boost spending. As the economy rebounds, the bank will raise interest rates again to avoid excessive inflation.

For consumers, a rise in interest rates can have an impact on finances.

"Mortgage rates start going up. If you've got balances leftover on your credit card, the interest rates on that go up," said Laidler. "Depending on what the state of your household is [and] what plans you have made these interest rate increases have consequences for you."

Okoye says the silver lining is that the Bank of Canada has a reputation of doing what it is expected to do.

WATCH| Bank of Canada explains why it isn't ready to hike rates yet:

Canadians told to prepare for rising interest rates

3 years ago

Duration 1:54

The Bank of Canada hasnt hiked its core lending rate despite record inflation, but it urged Canadians to prepare for interest rates to rise over the next year.

In January, the Bank of Canada decided to maintain the interest rate, but its governor Tiff Macklem warned that "everybody should expect interest rates to be on a rising path."

However, Laidler says that after underestimating how long inflation would stick around, the Bank of Canada has an important task ahead as it looks to slow it down.

"Now, really one of its major tasks, is to reestablish its credibility."