ECON10003Introductory MacroeconomicsLecture 3Inflation - Measures

Inflation - measuresThis is the first of two lectures relating to inflation.This lecture considers aspects of a range of measures of inflation with emphasis on the Consumer Price Index (CPI).The next lecture will look at the consequences of inflation. Why is the primary role of monetary policy the control of inflation?

*Inflation - measures Inflation: a sustained increase in the general price level.MeasuresThe Consumer Price IndexThe Producer Price IndexNational Accounts MeasuresThe GDP Implicit Price DeflatorGDP Chain Price Index

*Inflation - The Consumer Price IndexThe Consumer Price Index CPI A measure of the average price change of a representative basket of goods and services purchased by the typical metropolitan householdCalculated individually for the 8 capital cities and as a weighted average for all capitals together.Click here for ABS Consumer Price Index June quarter 2014

*Inflation - The Consumer Price IndexCalculated from direct observation of price change.The prices of approximately 8000 commodities go into calculating the CPI for each capital city. These goods and services are organized into groups (currently 11). Within the groups there are 90 smaller expenditure classes.

*Inflation - The Consumer Price IndexTo construct the CPI, similar goods and services are grouped together and in some chosen base year the cost to purchase that bundle is determined by reference to current period prices. So choose the base year as say 2012. If the bundle would cost $140 in 2012, then in index number form it would be 100.

Inflation - The Consumer Price IndexIf in 2013 the same bundle cost $143.50, then in index number form it would be $143.50/$140 = 102.5So the rate of inflation between 2012 and 2013 in this example, as measured by the CPI would be 2.5%, calculated as: CPI2013 - CPI2012 x 100 CPI2012*

Inflation - The Consumer Price IndexLevels (as index numbers), and rates of increase in prices, are shown for all the eleven individual groups and the 90 expenditure classes within the groups.The headline rate is then calculated as a weighted average of the expenditure classes. For a brief explanation, see:ABS Consumer Price Index- Explanatory NotesABS- A Guide to the Consumer Price Index

*Inflation - The Consumer Price IndexWeights are expenditure weightsWithin the 11 groups of goods and services, there are 90 expenditure classes.Each of these expenditure classes has its own weight or measure of relative importance. The price (and consequently the price change), of each of these 90 classes influences the overall measure of price (and price change) with an influence reflecting these expenditure weights. Weights are the percentage of total expenditure devoted to expenditure on each of the 90 classes.The weighting pattern is changed approximately every 5 years.

*Inflation - The Consumer Price Index In 2011 the ABS conducted a new household expenditure survey and introduced a new weighting pattern from the September qtr. 2011 in the calculation of the CPI. The commodity classification was also changed a little, such that the 11 groups are now called: Food and nonalcoholic beverages, Alcohol and tobacco, Clothing and footwear, Housing, Furnishings household equipment and services, Health, Transport, Communication, Recreation and culture, Education, and Insurance and financial services.

*Inflation - The Consumer Price Index In that same quarter it also introduced a seasonally adjusted measure of the CPI, which is very interesting. Would you expect the level and change in the level of prices to be influenced systematically by the time of year?

*Inflation - The Consumer Price IndexSimple average and weighted averageIndex Weight Index x WeightFood130 60%78Housing 100 10%10Clothing120 25%30 Automotive105 5%5.25Simple Avg.113.75 Weighted Avg. 123.25

Korean War Wool BoomOil Price Shock 1973Introduction of GST 2000Australias historical inflation rates

*Inflation - The Consumer Price IndexHeadline rate v. underlying rate of inflationThe headline rate, the one commonly referred to in the media, is the average of the 8 capital cities. The underlying rate refers to a CPI measure in which the influence of the price change of volatile items has been removed to give a longer term measure of inflation.

*Inflation - The Consumer Price IndexThe reason for an underlying measure of inflation arises from the policy need of the RBA in particular, to look at trend, rather than one-off influences, such as the introduction of the GST, or the effects of other volatile influences such as movements in prices of fruit and vegetables due to climatic factors.

*Inflation - The Consumer Price IndexThere are a number of estimates of the underlying inflation rate provided by the ABS, which are CPI based, but from which are removed the price (and price change) of various goods and services.

*The CPI - underlying ratesMarket Goods and Services excluding volatile items (formerly titled Private-sector prices) is the CPI (all groups) less fruit, vegetables, utilities, property rates and charges, health services, pharmaceuticals, automotive fuel, other motoring charges, urban transport fares, postal, education and child care.

*The CPI - underlying ratesIn the June quarter 2014, this group showed an increase from the June quarter 2013 of 2.3%, compared with 3.0% for the headline CPI.For the 3 month period March quarter 2014 to June quarter 2014, this group increased 0.7% compared with 0.5% for the headline CPI.

*The CPI - underlying ratesSometimes, however, the difference between the headline rate and the underlying rate can be large and provides useful insights into the sources of inflation and, in turn, the likely direction of monetary policy.*

*The CPI - underlying ratesFor example, in the December quarter of 2006 the headline rate of increase in the CPI from the previous quarter was -0.1%, while the increase in the Market Goods and Services Excluding Volatile Items was 0.7%.What do you think this would have suggested to the Reserve Bank?

*The CPI - underlying ratesNote that the CPI has generally been used as a measure of change in household cost of living. While change in interest rates does affect this, currently they are not included in the CPI.

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*The CPI - underlying ratesOn the previous slide you will see two other methods of looking at underlying inflation the weighted median and the trimmed mean measures.The ABS. now refers to these as Underlying Trend Series.

*The CPI - underlying ratesThe trimmed mean is obtained by ordering, in terms of the rate of increase, the 90 expenditure classes of the CPI, and taking the expenditure weighted average of the middle 70% of these so it ignores the highest and lowest increases.The weighted median, is the price change of the (one) expenditure class in the middle of this ordering.

The CPI - underlying ratesSo for the year, June qtr 2013 - June qtr 2014, the headline rate of CPI increase was 3.0% while the other two measures were:Trimmed mean was 2.9%Weighted median was 2.7%

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The CPI - underlying ratesFor the three months, March qtr 2014 - June qtr 2014, the headline rate of CPI increase was 0.5% while the other two measures were:Trimmed mean was 0.8%Weighted median was 0.6%

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*The CPI -Tradeables and Non-TradeablesAnother distinction that can be made is between tradable and non-tradable goods and services.The rate of increase of the non-tradable component of the CPI reflects the increase arising from domestic sources only. So with an appreciation of the AUD, as Australia has experienced for some years, you might find that the lower import prices that result, would keep the headline inflation rate below that arising from domestic sources. The RBA has often made reference to this distinction.

*The CPI -Tradeables and Non-TradeablesSo take the inflation rate for December 2003 to December 2004 released in February 2005.Headline rate 2.5%Tradables 1.3%Non-tradables 3.5%

The RBA raised the cash rate in March 2005 as it conducts monetary policy with the aim of maintaining the (headline) CPI rate of inflation within a 2-3 per cent band. But it was in the middle of this band - now look at the increase in non-tradeables.

*The CPI -Tradeables and Non-TradeablesFor the year, June quarter 2013 to June quarter 2014.Headline rate 3.0%Tradables 2.9%Non-tradables 3.1%And for the 3 months, March quarter 2014 to June quarter 2014Headline rate 0.5%Tradables 0.6%Non-tradables 0.5%

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*Features of the CPIFeatures of the CPIIncludes the price change of imported goods and servicesDoes not include the price change of all goods and services.Takes expenditure patterns of metropolitan households onlyIgnores a range of alleged biases from period to period such that it overstates the rate of inflation.

*There may be a bias caused by the introduction of new goods. Over time some goods are replaced by new goods that perform the same task better and/or perform more tasks.The McTaggart et. al. textbook give the example of a PC replacing a typewriter (but also does more). But the PC costs more to produce than the typewriter so including the higher price of a PC in the basket of goods and services rather than the typewriter provides an upward bias in the CPI.Possible Biases in the CPI Measure of Inflation

*Possible Biases in the CPI Measure of InflationAn upward bias may be introduced into the CPI due to improvements in the quality of goods and services. Product improvement may result from higher costs and generate higher prices. But economists would not consider this as inflation if the price increase is consistent with the quality improvement. However, the CPI will be increased by any such quality improvement and associated price increase.

*Possible Biases in the CPI Measure of InflationYour text book by Bernanke et. al. suggest a way to think about this issue. If you pay 20% more for a pizza that is 20% larger then the price per unit of the product is the same, so the higher price of pizzas should not contribute to a measure of inflation.

*Possible Biases in the CPI Measure of InflationThe substitution bias. Remember the CPI is a weighted average of the price change of thousands of different consumer goods and services purchased by the typical metropolitan household. The weights are the proportion of total household expenditure devoted to spending on each of the 90 different expenditure classes of goods and services.

*Possible Biases in the CPI Measure of InflationSo the price change of the goods and services on which we spend the largest proportion of total spending, influences the CPI by the largest amount.These weights are determined from household expenditure surveys which the ABS undertakes approximately every five years. In between these surveys, the weights are not altered.

*Possible Biases in the CPI Measure of InflationThis is how a substitution bias may occur in the short-run, such that the CPI overstates the increase in the cost of living.When the price of a product rises, we would expect that consumers would tend to substitute relatively cheaper substitute products. The extent of any substitution would depend on the degree of substitutability.

*Possible Biases in the CPI Measure of InflationBut if consumers substitute away from products with a relatively higher price, the expenditure weight attaching to that product is inaccurate. It will reflect a greater amount of expenditure than is actually occurring.So the influence of that higher price will exert too large an impact on the overall CPI measure, suggesting an increase in the cost of living which is greater than is actually occurring.

*Possible Biases in the CPI Measure of Inflation So how significant are these biases? A recent US study concluded that the CPI in that country over states inflation by 1.1 percentage points a year. Of this, 0.4 points was the substitution bias or that fact that the CPI is a fixed weight measure, 0.6 points was due to the new products and product improvement bias, and 0.1 points was due to a failure of the measure to take account of the growth of discount stores. See Boskin M., et. al., American Economic Review (May, 1997)

*The CPI and the Cost of LivingThe Consumer Price Index is often criticized as being an inadequate or inappropriate measure of the cost of living.What is the basis of this criticism?Remember the CPI is intended to be a measure of inflation NOT the cost of living necessarily.The ABS provides other measures of the cost of living which show that, recently, the cost of living has increased at a higher rate than the CPI.

*The CPI and the Cost of LivingFor example, in the June quarter 2012 (the latest), the CPI increased 0.5%, while the Analytical Living Cost Index (ALCI) of the ABS increased by 0.5% for Employee Households and also by 0.5% for Age Pensioner Households and by 0.4% for Self-Funded Retiree Households.Sometimes, however, the differences can be significant.SeeABS: Analytical Cost Indexes, June quarter 2012

The CPI and the Cost of LivingIn this publication, the ABS reports: Employee households have a relatively higher proportion of expenditure on furnishings, household equipment and services, transport and food and non-alcoholic beverages than the CPI population,.... ANDAge pensioner households have a relatively higher proportion of expenditure on food and non-alcoholic beverages and health than the CPI population,..

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*The Producer Price IndexThe producer price index measures the price change of intermediate goods, or of goods purchased by firms from other firms.It is published in two ways:On an economy wide basis by stage or level of production.On an industry specific basis, where those industries produce principally intermediate goods. eg. construction, selected manufacturing, mining and service industries.

*The Producer Price IndexThe significance of the PPI, is that the price change of intermediate goods will feed into costs of production of consumer goods and services, and so the PPI might act as a leading indicator of CPI movement.

*The Producer Price IndexProducer Price Index June 2013 June Quarter 2014Final (stage 3) 2.3%Domestic 1.9%Imports 6.4%

March Quarter 2014 June Quarter 2014 Final (stage 3) -0.1%Domestic 0.1%Imports -1.5%See: http://www.abs.gov.au/ausstats/abs@.nsf/mf/6427.0

*National Accounts Measures of InflationNational Accounts MeasuresThe GDP Implicit Price DeflatorGDP Chain Price IndexThese are both measures of the price change of all the goods and services that enter into GDP. They are measures of the price change of final goods and services therefore. However, the basis of the measures is different statistically.

*National Accounts Measures of Inflation The GDP implicit price deflator is calculated as Nominal GDP X 100 Real GDPand is presented in index number form.So nominal GDP or GDP at current prices, is the sum of the value of goods and services produced, where the valuation is in terms of the prices of the current period.

*National Accounts Measures of Inflation

Real GDP is the sum of the value of goods and services where the valuation removes the influence of price change.Dividing the first of these by the second, gives a measure of the price change of all of those final goods and services that enter into GDP.

The ABS has stated that its preferred National Accounts measure of inflation is the GDP Chain Price Index.

*National Accounts Measures of Inflation The GDP Chain Price Index is a measure of the price change of all those final goods and services entering into GDP, calculated in a manner similar (statistically) to the GDP chain volume measure of real GDP. So they are chain Laspeyres price indexes.

*Calculating The Chain Price Index

For example, to calculate the rate of inflation between 2007 and 2008.The ABS states that the chain price index is the better measure and that it only calculates and publishes the implicit price deflator since some historical contracts have an indexation clause using the IPD.

*National Accounts Measures of Inflation In particular we pay most attention to the chain price index for the component household final consumption expenditure, rather than all final goods and services, when we focus on a cost of living measurement.

*National Accounts Measures of InflationThe most obvious limitation of measures of inflation provided in the national accounts is the time delay in publishing the information.Also, all data published in the National Accounts are subject to revision after they are first published.

* Differences in Measures of InflationNotice that these three sets of measures of inflation are looking at the price and price change of different goods and services.The CPI only includes final consumer goods and includes imports of such goods and services.

* Differences in Measures of InflationThe national accounts measures also include only final goods, but this is both final consumer goods and capital goods. But only those goods produced domestically.The PPI only includes intermediate goods, but some of these will in fact be capital goods and does include imports. There are no consumer goods included.

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