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What Is Inflation?

What Is Inflation?

Inflation is the change in the level of prices and the corresponding change in purchasing power that results. Most of the time, people associate the “Consumer Price Index” or “CPI” with inflation. This is the change in the price of a “shopping basket” of consumer goods for a country that the national statistics agency has sampled over time on a monthly basis. The “core CPI” is the change in prices without the food and energy components, or “ex food and energy”. Since food and energy prices are volatile, the “core CPI” is thought to be a more accurate measure of underlying inflation.

When inflation increases, purchasing power decreases because each dollar buys less real, tangible goods than it did before. Inflation is therefore an important consideration for anyone living on a fixed income.

The main challenge in measuring inflation is establishing prices to use for the calculation. National statistics agencies usually measure various inflation rates:

  • The “raw materials price index” (RMPI), or so-called “crude goods” price index, which measures commodity price inflation; price changes for raw materials purchased by industries in Canada for further processing.
  • The “industrial product price index” (IPPI), which measures changes in the wholesale price of goods at ‘the factory door'; commodities sold by Canadian manufacturers, and
  • The “consumer price index” (CPI), which measures the change in retail prices.

Since economists, market strategists, and politicians are usually concerned with changes in consumer prices, the CPI is the most frequently used measure of price change. Across a country, however, prices vary with market conditions, supply and demand, transportation costs and other factors.

For example, the price of unleaded gasoline varies across Canada by a significant amount. This reflects transportation costs, supply of gasoline, and the gasoline sales taxes in each province. To properly measure these differences, Statistics Canada measures the CPI in each major urban centre to create a sample by province and territory. It then combines them on a weighted basis to create the national Canadian CPI index. It is not unusual to have major differences, as much as one to two per cent, in the CPI between different provinces and cities. This means where you live has a major impact on whether the CPI is a proper measure of your inflation.

Inflation is an important consideration for anyone living on a fixed income.

Another issue is the appropriateness of the sample of goods and services that make up the “basket of goods” for the CPI to consumers. Statistics Canada actually samples prices by having “shoppers” visit retail stores on a monthly basis and price consumer goods and services. The basket of goods is selected and weighted according to a specific year, and updated only over longer time periods.

The Canadian CPI was based on a 1980 sample of goods and not updated until 1995. This meant that the buying patterns of consumers in 1994 were assumed to be those from 1980. The rapid changes in our society meant that some goods important to 1994 consumers were not counted appropriately in the CPI because of its 1980 weightings. Some goods and services commonly used by consumers in 1994 had not even been thought of in 1980. Examples of this would be the home computer, automobile air bags and many consumer electronics.

Another issue is how relevant the basket is to the so-called average consumer. If your children only will wear expensive “brand name” running shoes, your price level change has been quite high. If they wear generic shoes, the CPI has probably reflected your price level change accurately.

Changing buying patterns can impact the CPI. Average household spending on telecommunications has more than tripled since 1982, which reveals the ‘interconnectedness’ of today’s society, driven by our adoption of advances in technology.

All things considered, the CPI in most modern industrial countries is thought to be a fairly accurate reflection of the change in the retail price level. This is important since CPI is used to index government pensions and benefits, as well as tax brackets. The CPI is also used to convert the nominal national accounting statistics, such as “Gross National Product” to a “real” or after-inflation basis. With the issuing of inflation-linked bonds, CPI has also been used to calculate the principal increase for this “real” bond.