Inflation

Inflation explained

Simply put, inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition is a way to show how prices change over time. Inflation relates to the “purchasing power” of money – meaning the same amount of money will buy fewer goods and services over time.

Inflation is represented by the percentage change in the consumer price index (CPI), which measures the cost of a basket of 600 goods and services, including housing, transportation, furniture, clothing and recreation. The Bank of CanadaBank of Canada The central bank that sets Canada’s money policies. These policies help keep the Canadian dollar stable. They also affect our economy and our money supply. The goal of the Bank of Canada is to keep currency and the financial system stable. They are the sole authority to issue banknotes – bills.+ read full definition has a current target to keep inflation between 1 to 3 per cent annually.

While inflation is generally associated with rising prices, deflationDeflation A drop in the cost of goods and services over time. Often happens when the supply of money or credit shrinks, or when consumers or government cut spending. This means the same number of dollars will buy more.+ read full definition is experienced when prices are falling.

Inflation calculator

Use this calculator from the Bank of Canada to see how prices have changed in the last 100 years.

Inflation risk

Inflation riskInflation risk The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation.+ read full definition is the risk that your purchasing power will be reduced if the value of your investments does not keep up with inflation. Inflation risk is particularly relevant if you own cash or debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition investments like bonds. Shares offer some protection against inflation because most companies can increase the prices that they charge to their customers.

Learn about other types of investment risk.

The effect of inflation on your investments

Inflation means higher consumer prices. This often slows sales and reduces profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition. Higher prices will also often lead to higher interest rates. For example, the Bank of Canada may raise interest rates to slow down inflation. These changes tend to bring down stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition prices. Commodities however, may do better with inflation, so their prices may rise.

The effect of deflation on your investments

Falling prices often mean lower profits for companies and decreased economic activity. Stock prices may go down, and investors may start selling their shares and moving to fixed-income investments like bonds. Interest rates may be lowered to encourage people to borrow more. The goal is to spur increased spending and economic activity. The Great Depression (1929-1939) was one of the worst periods of deflation ever.

How inflation affects your investment returns

Nominal rate of return

The amount of money you make on an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition before expenses – this rate of return does not take inflation into accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition.

Real rate of return

Your real rate of return is the nominal return on your investment minus the inflation rate, and gives you a better sense of the purchasing power of the money you make from your investments.

Key point

Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services.

Take action

Use this calculator from the Bank of Canada to see how prices have changed in the last 100 years.