Inflation, Deflation, and what it means to you

“Inflation” and “deflation” seem to be the most whispered about words in economic circles right now.  Canada’s Finance Minister Jim Flaherty commented today that he is satisfied with the Bank of Canada’s mandate to keep inflation rates at or below 2%; elsewhere all eyes are on China as its central bank issued new regulations today in an attempt to curb their rising inflation.

What’s the deal with inflation? Is it really such a bad thing? And how does the Bank of Canada go about affecting the inflation rate?

Inflation is essentially the gradual increase in the price of goods and services over time. There’s nothing wrong with the inflation that occurs naturally in the economy as wages rise. In fact, this natural inflation is necessary. For example, if the price of something like bread didn’t rise as wages rose then we’d still have $0.25 loaves of bread which would be great but no one would want to bake loaves of bread to sell for $0.25 so we’d have no bread.

So if inflation is bad then the opposite of inflation must be good right? Deflation is the gradual decrease in the cost of goods and services over time. Look at it this way, if deflation is high then it means the price of things like cars is steadily falling. Why then would you buy a car today if you could wait until next week when it’s cheaper? And if everyone behaved this way then no one would be spending any money. Without anyone spending money, who is going to make any money? Wages will go down because your company didn’t make enough money to pay you.

Like most things, inflation and deflation are perfectly fine and even beneficial if they occur in moderation. Moderate inflation helps you out by raising your wages over time. Moderate deflation also helps you out by encouraging people to develop more efficient ways to produce goods and services.

Basically it’s like this: deflation is typically worse than inflation because deflation stops people from spending money. Inflation at low levels is alright but inflation at higher levels makes people spend more money and save less.

This is where the central bank steps in. It directly controls interest rates so it can make it more attractive for people to save money by increasing the interest rate you would receive if you invested your money instead of spending it.

It also directs commercial banks about how much of their clients’ money they have to keep on hand and how much of it they can lend out. If they order commercial banks to hold more money then less will be lent out and spent and more will be saved.

So the next time you see a headline that says “Inflation rate on the rise” you’ll know that it’s an indication that interest rates might also be close to rising. And if you’re on the lookout for buying a home or refinancing your mortgage then you’d be wise to look into your options now.