ECON10003

Introductory Macroeconomics
Lecture 3
Inflation - Measures

Inflation - measures
This 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.
Measures
The Consumer Price Index
The Producer Price Index
National Accounts Measures
The GDP Implicit Price Deflator
GDP Chain Price Index

Inflation - The Consumer Price Index

The Consumer Price Index CPI
A measure of the average price change of
a representative basket of goods and
services purchased by the typical
metropolitan household

Calculated 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
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Inflation - The Consumer Price Index

Calculated 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.
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Inflation - The Consumer Price Index

To 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.
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Inflation - The Consumer Price Index

If in 2013 the same bundle cost $143.50,
then in index number form it would be
$143.50/$140 = 102.5
So 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
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Inflation - The Consumer Price Index

Levels (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 Notes
ABS- A Guide to the Consumer Price Index

Inflation - The Consumer Price Index

Weights are expenditure weights
Within 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.
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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.
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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?

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Inflation - The Consumer Price Index

Simple average and weighted average
Index Weight Index x Weight
Food
130
60%
78
Housing
100
10%
10
Clothing
120
25%
30
Automotive 105
5%
5.25
Simple Avg. 113.75
Weighted Avg. 123.25

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Australias historical
inflation rates
Korean War Wool Boom
Oil Price Shock 1973

Introduction of GST 2000

Inflation - The Consumer Price Index

Headline rate v. underlying rate of
inflation
The 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.
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Inflation - The Consumer Price Index

The 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.
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Inflation - The Consumer Price Index

There 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.

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The CPI - underlying rates

Market Goods and Services excluding
volatile items (formerly titled Privatesector 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.
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The CPI - underlying rates

In 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.
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The CPI - underlying rates

Sometimes, 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.

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The CPI - underlying rates

For 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?
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The CPI - underlying rates

Note 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 rates

On 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.

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The CPI - underlying rates

The 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.
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The CPI - underlying rates

So 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 rates

For 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-Tradeables

Another 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.
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The CPI -Tradeables and Non-Tradeables

So 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.
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The CPI -Tradeables and Non-Tradeables

For 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 2014
Headline rate 0.5%
Tradables 0.6%
Non-tradables 0.5%
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Features of the CPI

Features of the CPI
Includes the price change of imported goods
and services
Does not include the price change of all
goods and services.
Takes expenditure patterns of metropolitan
households only
Ignores a range of alleged biases from period
to period such that it overstates the rate of
inflation.
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Possible Biases in the CPI Measure 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.
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Possible Biases in the CPI Measure of

Inflation
An 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.
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Possible Biases in the CPI Measure of

Inflation
Your 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.

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Possible Biases in the CPI Measure of

Inflation
The 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.
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Possible Biases in the CPI Measure of

Inflation
So 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.
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Possible Biases in the CPI Measure of

Inflation
This 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.

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Possible Biases in the CPI Measure of

Inflation
But 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.
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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)
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The CPI and the Cost of Living

The 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 .

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The CPI and the Cost of Living

For 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.
See
ABS: Analytical Cost Indexes, June quarter 2012
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The CPI and the Cost of Living

In 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,.... AND
Age 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 Index

The 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.
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The Producer Price Index

The 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.

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The Producer Price Index

Producer Price Index
June 2013 June Quarter 2014
Final (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/64
27.0
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National Accounts Measures of Inflation

National Accounts Measures
The GDP Implicit Price Deflator
GDP Chain Price Index

These 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.
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National Accounts Measures of Inflation

The GDP implicit price deflator is calculated as
Nominal GDP X 100
Real GDP
and 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.
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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.
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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.

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Calculating The Chain Price Index

For example, to calculate the rate of inflation
between 2007 and 2008.

p q
p q
M

i 1

i , 08

i , 07

i , 07

i , 07

i 1

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.
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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.

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National Accounts Measures of Inflation

The 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.

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Differences in Measures of Inflation

Notice 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.

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Differences in Measures of Inflation

The 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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