Pandemic inflation 101 — why gas, beer cost more
A primer on why prices are rising in Canada and what history says comes next
WATERLOO It’s hard to go anywhere these days without the dreaded “I” word coming up.
Inflation — it’s at the gas pumps, it’s in the grocery stores and it’s entrenched inside our collective minds.
But while most of us associate inflation with higher prices, what exactly does it mean and where does it come from?
Step inside the classroom of longtime Wilfrid Laurier University economics professor David Johnson, a Harvard-educated former employee of the Bank of Canada who has taught first-year economics classes more times than he can remember.
In its purest form, he said, inflation is an equal percentage increase in the price of everything and in the wages that people earn.
So, if beer and pizza both rise in price by 10 per cent, he’ll say to a room full of 18-year-olds, your wage also rises by 10 per cent.
In layman’s terms: what you can buy with what you earn remains the same.
When inflation is increasing, he said, it refers to a decline in purchasing power for a given currency. In Canada, that means you could buy more with one Canadian dollar yesterday than you can buy with it today.
When the Bank of Canada talks about the current level of inflation, it is referring to the Consumer Price Index, or CPI, which measures price change by comparing the cost of a fixed basket of more than 700 goods and services.
Shelter and transportation make up about half of the total calculation, and the remaining half is split between the other six categories — food, household spending, clothing and footwear, health, recreation and alcohol and tobacco.
But they’re not all treated equally; each item in the basket is weighted differently to reflect how much Canadian consumers spend on it.
An increase in rent, for example, has a bigger impact on the overall CPI measure than an increase in the cost of milk.
Therefore, a large increase in the cost of housing or gas — both of which we’re seeing today in Canada — can have a dramatic impact on inflation rates, said Johnson.
Typically, the Bank of Canada likes to keep inflation between one and three per cent — two per cent is the goal. As of the latest numbers from March, it is currently at 6.7 per cent.
So, why is this happening?
If we look to the medieval world that used silver as its currency, Johnson explains, imagine that bread originally costs two silver coins.
Then suddenly there’s a great discovery of silver, and there’s more of it in circulation.
More people have it, so the price of bread goes up to four coins, and the wage for workers also increases.
“We’re pretty sure that one of the things that changes the price level is the quantity of money,” he said.
During the pandemic, central banks around the world “made the choice to hand out lots of money to maintain people’s ability to buy things.”
However, despite receiving those funds, lockdowns forced consumers inside for nearly two years and limited what they could buy.
So, most households saved more than usual, and now have the means and demand to spend.
Simultaneously around the world, the pandemic forced factories to shut down for long periods of time, disrupting supply chains, and creating excess demand for products like cars, couches and video game consoles.
Have you tried buying a new car or a PlayStation 5 lately? Good luck.
“So, the pandemic piece is really about less supply and governments acting to keep demand the same by giving people money.”
This was done through programs like the Canadian Emergency Response Benefit, which gave $2,000 a month for unemployed workers throughout the pandemic.
Countries around the world followed similar strategies.
The question of whether that spending went on too long will be discussed in macroeconomics classes for years to come, predicts Johnson.
In the meantime, Canada’s central bank is on an ambitious path to curb inflation, signalling it will aggressively raise interest rates to make it more expensive to borrow money.
Shelter makes up about 30 per cent of the CPI calculation; decreasing demand for housing could go a long way to ease inflation closer to two per cent.
However, the risk is that demand drops so low that it causes a recession, which Johnson describes as “people buying less stuff and therefore fewer people being employed to make the less stuff being bought.”
Most recessions in Canada happened because the government raised taxes at a rate that discouraged consumers from spending, the central bank aggressively raised interest rates to lower the demand to borrow money, or the Canadian dollar increased so that other countries bought less of our exports.
With interest rates rising rapidly, is a recession inevitable in Canada? Not necessarily, said Johnson. Occasionally, central banks handle the situation just right and reduce demand enough to reduce the inflation rate, but not generate lots of job losses.
This is known as a “soft landing.” “How hard is it to do? Well, it’s hard. It’s kind of like riding a unicycle — there’s lots of ways to make a mistake,” he said.
“In general, it is challenging to reduce inflation without causing a recession, but it’s not impossible.”
Unfortunately, he said, there are a lot more examples of unsuccessful attempts by central banks to pull this off than there are success stories.
Central banks don’t work in a vacuum, and unforeseen global events can destroy even the best laid-out plan.
Another strain of the virus? An escalation of the war in Ukraine? A giant meteor headed for the planet?
All these possible events will determine the path forward, and no one knows exactly where it will end up.
‘‘ We’re pretty sure that one of the things that changes the price level is the quantity of money.
DAVID JOHNSON ECONOMICS PROFESSOR AT WILFRID LAURIER UNIVERSITY