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### Student Question

Secondary V • 2yr.

Hello, what are inflation and monetary policy. I read in my notebook but it's too complicated. Can you explain it to me? Please

Financial Education

## Explanations (1)

• Explanation from Alloprof

Explanation from Alloprof

This Explanation was submitted by a member of the Alloprof team.

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Team Alloprof • 2yr.

Hi,

Inflation and monetary policy are two related elements, because Canada's monetary policy is mainly the control of inflation in the country.

Lets first define inflation according to the Bank of Canada : “Inflation is a persistent rise in the average level of prices over time. “

Why are prices going up? Prices tend to rise when the demand for goods and services by consumers is greater than what is offered by the businesses. For example, if there are only 5 televisions for sale (offer) and 20 people want them (demand), the seller will sell his 5 televisions at the highest price as long as there are still 5 people willing to pay that price.

To measure inflation, the Bank of Canada looks at what is called the consumer price index (CPI), which is the evolution of the average Canadian household spending (spendings of a socio-economically average Canadian family).

Since it is impossible to keep track of ALL the expenses of ALL Canadian households, Statistics Canada is responsible for filling out a virtual shopping cart containing approximately 700 most common goods and services. Each month, Statistics Canada calculates how much it would cost to buy all of these items. They then compare the change in price to the previous month to calculate the increase or decrease in the Consumer Price Index (CPI).

In this famous virtual basket, there are several categories of items:

• Food: groceries and meals at restaurants
• Housing: rent and mortgage costs, home insurance, repairs and maintenance, property tax and public services
• Transport: vehicles, gasoline, auto insurance, repairs and maintenance, and public transportation
• Household expenses: telephone, Internet, child care, cleaning products, and furniture and appliances
• Clothing: clothing, shoes, jewelry and dry cleaning
• Health care and personal care: prescription drugs, dental care, health care, hairdresser and personal care products
• Sports, travel, training and recreation
• Alcohol, tobacco products and recreational cannabis

However, Statistics Canada gives each item in this virtual basket a certain "weight" according to the amount that the average Canadian household spends on it. For example, since most Canadians spend more on groceries and rent than on hairdressing, food and housing have a higher weight in the CPI than personal care. So the more weight an item has, the more impact it has on the cost of living of the average household.

Therefore, inflation is the calculation of the persistent increase in the average level of the CPI over time! :)

Monetary policy relates to the amount and value of money in circulation in the economy. The quantity and value of currency in circulation will be influenced by the central element of the Bank of Canada's monetary policy - its strategy to control inflation. The Bank of Canada's goal is to keep the inflation rate at around 2%, which is the midpoint of a target range of 1% to 3%.

So, when the Bank of Canada finds that the inflation rate is too high, it lowers its interest rate. Money loans are then made at lower interest rates which reduces consumer prices. The CPI falls, influencing the rate of inflation downwards. Similarly, when the Bank of Canada finds that the inflation rate is too low, it increases its interest rate. Therefore, it lends money at a higher rate, which has an impact on borrowers and the entire economic chain, thus pushing up consumer prices. The CPI rises, pushing the inflation rate up!

I hope it's clearer to you. Do not hesitate to write to us again if it is still not clear or if you have other questions! :)