In 1991, a Canadian worker who was paid by the hour earned $14.01 per hour, on average. By 2011, the average wage had risen to $21.75 per hour. Similarly, in 1991, a Canadian worker on a fixed salary earned the equivalent of $18.70 per hour, on average. By 2011, this salary had risen to $31.64 per hour, on average.

But wait. Canadian workers were paid much more in 2011, but they also faced a much higher cost of living. For example, from 1991 to 2011 the price of coffee rose by 56% and the price of gasoline rose by 118%. Figure 6-8 compares the percentage increase in hourly earnings between 1991 and 2011 with the increases in the prices of some standard items: the average worker’s paycheque went further in terms of some goods, but less far in terms of others. Although income for both types of workers increased more than the overall increase in the cost of living (45%), salaried workers fared better than hourly paid workers. Salaried workers’ hourly pay rose by 24 percentage points more than the Consumer Price Index (CPI) did over this period compared to only a 10 percentage point gain for their hourly paid counterparts over the CPI.

The point is that between 1991 and 2011 the economy experienced substantial inflation: a rise in the overall level of prices. Understanding the causes of inflation and its opposite, deflation—a fall in the overall level of prices—is another main concern of macroeconomics.

You might think that changes in the overall level of prices are just a matter of supply and demand. For example, higher gasoline prices reflect the higher price of crude oil, and higher crude oil prices reflect such factors as the exhaustion of major oil fields, growing demand from China and other emerging economies as more people grow rich enough to buy cars, and so on. Can’t we just add up what happens in each of these markets to find out what happens to the overall level of prices?

The answer is no, we can’t. Supply and demand can only explain why a particular good or service becomes more expensive relative to other goods and services. It can’t explain why, for example, the price of chicken has risen over time in spite of the facts that chicken production has become more efficient (you don’t want to know) and that chicken has become substantially cheaper compared to other goods.

What causes the overall level of prices to rise or fall? As we’ll learn in Chapter 8, in the short run, movements in inflation are closely related to the business cycle. When the economy is depressed and jobs are hard to find, inflation tends to fall; when the economy is booming, inflation tends to rise. For example, prices of most goods and services fell sharply during the terrible recession of 1929–1933.

In the long run, by contrast, the overall level of prices is mainly determined by changes in the money supply, the total quantity of assets that can be readily used to make purchases. As we’ll see in Chapter 16, hyperinflation, in which prices rise by thousands or hundreds of thousands of percent, invariably occurs when governments print money to pay a large part of their bills.

Both inflation and deflation can pose problems for the economy. Here are two examples: inflation discourages people from holding on to cash, because cash loses value over time if the overall price level is rising. That is, inflation causes the amount of goods and services you can buy with a given amount of cash to fall. In extreme cases, people stop holding cash altogether and turn to barter. Deflation can cause the reverse problem. If the price level is falling, cash gains value over time as it buys more and more goods and services than previously. In other words, the amount of goods and sevices you can buy with a given amount of cash increases. So holding on to it can become more attractive than spending on some goods or investing in new factories and other productive assets. This can deepen a recession.

We’ll describe other costs of inflation and deflation in Chapters 8 and 16. For now, let’s just note that, in general, economists regard price stability—in which the overall level of prices is changing, if at all, only slowly—as a desirable goal. Price stability is a goal that seemed far out of reach for much of the post–World War II period but was achieved to most macroeconomists’ satisfaction in the 1990s.