Since the Second World War, Canada has experienced inflation of one sort or another. At times the inflation has been mild. It would have taken $1.13 in 1955 to buy what $1.00 bought in 1950 and only $1.10 in 2005 for a dollar’s worth of the same goods and services in 2000. In other periods inflations was more severe. Prices doubled between 1975 and 1983, though the recession of the 1990s brought cost of living increases under control and there was only an 18 percent increase over the course of the decade (For comparisons, check out this cost of living calculator).
Most economists think that moderate inflation is good for the economy and the Bank of Canada’s policy is try to keep to keep the inflation rate about two percent. One of the main reasons for this is a phenomenon first described by the great British economist, John Maynard Keynes—the money illusion. Many economists believe that workers and consumers think of money in terms of the numbers printed on it. A hundred dollars is a hundred dollars. I get paid fifty thousand dollars a year, etc. They don’t think of money in “real” terms, that is, in terms of what the money can buy. The average person would say, “I earn fifty thousand dollars a year, but the cost of living has gone up.” From an economist’s perspective, the purchasing power of the person’s salary has declined.
This phenomenon has profound implications. There are times when an employer needs to cut costs. Although employees don’t like wage freezes, there are circumstances under which they will accept them. Because of the money illusion, they don’t they feel that they are any worse off, even though their “real” income has declined by two percent. By contrast, people react violently to a cut in their wages or salary.
I knew someone who had been a teacher in the 1930s. Her salary had been reduced and even 60 years later she still felt a bitter sense of grievance. She had probably not been any worse off, though, because the cost of living actually declined by almost 25 percent in the period from 1930 to 1935. She may even have been better off, but I never did manage to convince her of that. The fact that she took home fewer dollars each week had left a scar.
The official rate of inflation also exaggerates what is really happening in everyday life. Statistics Canada puts together a “basket” of goods and services that the average Canadian buys and bases core inflation around it. It also produces another inflation number that includes the price of two necessary items, gas and food, whose prices are volatile.
It changes the items in the basket from time to time, but it can’t change them too often, or it wouldn’t be possible to make meaningful comparisons over time. Consumers, by contrast, can make instant changes in their behaviour. If bananas go up in price, I can by apples. If steak becomes more expensive, I can eat more lamb. Out go the green beans, in comes the corn, and so forth. If England becomes too expensive for a holiday, there’s always Guatemala. If foreign travel is costly, PEI is lovely this time of year. Substituting doesn’t completely eliminate the inflation number the Bank of Canada gives us, but it reduces it significantly.
Worry if you see core inflation go above four percent. Don’t worry about the price of gas at the pump, though everyone is entitled to grumble.