Measuring prices and inflation

Inflation is a sustained rise in the general level of prices. When inflation is 3 %, a basket of goods and services that cost 100 dollars last year costs about 103 dollars this year, and each dollar buys about 3 % less. For most of the period from the early 1990s to 2020, inflation in Canada and the United States stayed close to 2 % and attracted little public attention. Then, in 2021 and 2022, it surged to the highest rates in four decades, and cost of living became a dominant political issue. In 2026 an oil price shock pushed headline inflation up again. This lesson explains how inflation is measured, why the measures differ, what inflation costs, and what the 2021–2023 episode taught economists.

Price indexes

A price index measures the cost of a fixed basket of goods and services relative to its cost in a base period. The most widely watched is the consumer price index (CPI), which tracks the prices that households pay. To build it, a statistical agency first surveys household spending to decide what goes into the basket and how much weight each item gets. Shelter might be weighted at about a quarter or more of the basket, food at about a sixth, transportation at about a sixth, and so on. Each month, price collectors record the prices of thousands of specific items across the country. The agency then calculates the cost of the basket at current prices, divides by its cost in the base period, and multiplies by 100.

The inflation rate is the percentage change in the price index, usually measured over twelve months to avoid seasonal patterns. If the CPI rises from 160.0 to 164.8 over a year, the inflation rate is \( (164.8 - 160.0) \div 160.0 \times 100 = 3.0 \) %. Monthly changes are often reported too, sometimes after seasonal adjustment, and can be annualized in the same way as quarterly GDP growth.

# CPI from a weighted basket and item contributions to inflation
basket = {  # item: (quantity, base price, current price)
    'Food (kg)':        (10, 6.00, 6.30),
    'Rent (months)':    (1, 1500.00, 1560.00),
    'Gasoline (L)':       (60, 1.50, 1.80),
}
base = sum(q * p0 for q, p0, p1 in basket.values())
now = sum(q * p1 for q, p0, p1 in basket.values())
cpi = now / base * 100
print(f"Base cost {base:,.2f}  current cost {now:,.2f}  CPI {cpi:.1f}  inflation {cpi - 100:.1f} %")
for item, (q, p0, p1) in basket.items():
    weight = q * p0 / base
    change = p1 / p0 - 1
    print(f"  {item:18s} weight {weight * 100:5.1f} %  price change {change * 100:5.1f} %  "
          f"contribution {weight * change * 100:4.2f} pts")

Base cost 1,650.00  current cost 1,731.00  CPI 104.9  inflation 4.9 %
  Food (kg)          weight   3.6 %  price change   5.0 %  contribution 0.18 pts
  Rent (months)      weight  90.9 %  price change   4.0 %  contribution 3.64 pts
  Gasoline (L)       weight   5.5 %  price change  20.0 %  contribution 1.09 pts

The contributions add up to the overall inflation rate. Agencies publish similar breakdowns, which is how analysts can say, for example, that gasoline accounted for most of the rise in inflation in a given month.

Statistics Canada publishes the CPI monthly. The basket weights are updated regularly, now roughly every year, based on household spending data. Shelter, which includes rent, mortgage interest cost, property taxes, homeowners' replacement cost and utilities, is the largest component. Canada's treatment of owner-occupied housing includes mortgage interest costs, which means that when the Bank of Canada raises interest rates, measured inflation rises in the short run, a feature that has drawn criticism.

Core inflation and other measures

Headline CPI inflation can swing sharply because of volatile items such as gasoline and fresh food, whose prices respond to weather, wars and global commodity markets. Central banks therefore watch measures of core inflation that strip out or down-weight volatile components and give a better signal of underlying inflation pressure.

The Bank of Canada's preferred core measures are CPI-trim, which removes the 20 % of components with the largest price changes at each end of the distribution each month, and CPI-median, the price change at the 50th percentile of the weighted distribution. It also tracks CPI excluding food and energy. In September 2026, headline CPI inflation was 3.1 %, but CPI-trim was 1.8 % and CPI-median 1.9 %, telling the Bank that the surge in headline inflation was mostly about energy rather than broad-based price pressure.

The CPI and the GDP deflator differ in two main ways. The deflator covers all domestically produced goods and services, including capital goods and government services, while the CPI covers consumer purchases, including imports. So a rise in the price of imported cars raises the CPI but not the deflator, and a rise in the price of exported oil raises the deflator more than the CPI. And the CPI uses a fixed basket, while the deflator's weights reflect current production.

Is the CPI biased?

For decades economists have argued that a fixed-basket CPI tends to overstate increases in the cost of living. Substitution bias arises because consumers switch toward goods that have become relatively cheaper, but a fixed basket assumes they keep buying the same quantities. Quality bias arises when products improve: if a new phone costs the same as last year's but is faster and has a better camera, part of what looks like an unchanged price is really a price cut. New goods bias arises because new products enter the basket only after a delay, missing the early price declines and the gains to consumers from their availability. Outlet bias arises when consumers shift to discount stores and online sellers. A US commission led by Michael Boskin estimated in 1996 that these biases overstated inflation by about 1.1 percentage points a year; since then, agencies have adopted quality adjustments, more frequent basket updates and chained indexes, and the remaining bias is generally thought to be smaller, perhaps around half a point.

On the other hand, many households feel that official inflation understates their own experience. This is partly because frequently purchased items such as groceries and gasoline loom large in perception, partly because individual baskets differ from the average (renters, homeowners with new mortgages, and older people all face different price changes), and partly because people often compare current prices with those of several years ago rather than last year. The cumulative rise in the price level since 2020, around a fifth in both countries, has not been reversed even though inflation has come down. Lower inflation means prices are rising more slowly, not that they are falling.

Using price indexes: real values

Price indexes let us compare money amounts across time. To convert a dollar amount from year A into year B dollars, multiply by the ratio of the price index in year B to that in year A. A real wage is a nominal wage adjusted for inflation. If your hourly wage rose from 25 dollars to 26.50 dollars (a 6 % increase) while prices rose 4 %, your real wage rose by about 2 %; precisely, 1.06 ÷ 1.04 − 1 = 1.9 %.

Indexing ties payments to a price index so that their real value is preserved.

In Canada, Old Age Security, the Canada Pension Plan, the Canada Child Benefit and the federal income tax brackets are indexed to CPI inflation, as are many provincial benefits. Many collective agreements include cost-of-living adjustment clauses, though these became less common during the low-inflation decades.

Why inflation is costly

Moderate, predictable inflation is less harmful than many people believe, but high or unpredictable inflation imposes real costs. Shoe-leather costs are the resources spent minimizing cash holdings when money loses value quickly. Menu costs are the costs of changing prices frequently. Relative-price distortions arise because firms change prices at different times, so prices give misleading signals about relative scarcity. Tax distortions arise because tax systems are often based on nominal values: a capital gain that merely reflects inflation is still taxed, raising the effective tax on saving. Unexpected inflation redistributes wealth from lenders to borrowers, because loans are repaid in dollars that buy less than expected, and it hurts people on fixed nominal incomes. And high inflation creates uncertainty that makes long-term planning and contracting harder, discouraging investment.

Deflation, a sustained fall in the price level, is also costly. It raises the real burden of debts, can lead consumers to postpone purchases in expectation of lower prices, and limits central banks' ability to cut real interest rates when nominal rates are already near zero. Japan's experience with mild deflation from the late 1990s to the early 2010s is the standard cautionary example. This is one reason central banks aim for low positive inflation, typically 2 %, rather than zero.

Very high inflation, called hyperinflation (conventionally, more than 50 % a month), is almost always caused by governments printing money to finance large deficits. Germany in 1923, Zimbabwe in 2008 and Venezuela in the late 2010s are well-known cases. In these episodes, money loses its usefulness as a store of value and unit of account, and economic life is badly disrupted. Lesson 7 explains the link between money growth and inflation.

The inflation surge of 2021–2023

After the pandemic recession of 2020, inflation rose rapidly. In June 2022 twelve-month CPI inflation peaked at 8.1 % in Canada and 9.1 % in the United States, the highest since the early 1980s. Economists identify several causes, and still debate their relative importance. On the supply side, pandemic disruptions snarled global supply chains, shipping costs soared, semiconductor shortages limited car production, and Russia's invasion of Ukraine in February 2022 pushed up energy and food prices. On the demand side, large government support programs and very low interest rates boosted spending, and consumers shifted spending from services toward goods just when goods were hardest to supply. Labour markets became very tight, with job vacancies at record highs. Many economists now conclude that the combination of strong demand and constrained supply was what produced such high inflation; neither alone would have done it.

Inflation then fell. Supply chains recovered, energy prices eased, and central banks raised interest rates rapidly: the Bank of Canada from 0.25 % to 5 % between March 2022 and July 2023, and the Federal Reserve from near zero to a range of 5.25–5.50 % over a similar period. By 2024 inflation was back near target in both countries. Unusually, disinflation occurred without a recession and with only a modest rise in unemployment, an outcome sometimes described as a soft landing. Lessons 8, 9 and 12 examine the policy decisions in more detail.

In 2026 a new shock hit. After war broke out between the United States and Iran in late February 2026, oil prices rose sharply, with Brent crude spending long periods above 100 US dollars a barrel. Gasoline prices jumped by more than a quarter over the year, and headline inflation rose above 3 % in both countries. Central banks faced a classic dilemma, discussed in lesson 9: an oil shock raises prices while also weakening growth.