The visible hand in economics

Price indicies: A discussion

Posted on: July 25, 2008

Note: Other posts in this discussion are available under the tag “inflation debate“.

With the trade-off between inflation and other things behind us, and a justification for inflation targeting, we have a good base to discuss current activity and issues. The aim is to now discuss other methods of fighting inflation – however, before discussing this I think it is important to discuss another technical issue: How do we measure inflation?

This is both an incredibly important issue, and a highly contentious one. While I was going to write a long post on this, Dr Chinn at Econobrowser beat me to it (and also did an infinitely better job than I could have 😉 ). Dr Chinn discusses how we use the CPI to measure inflation, and the limitations of this measure (especially in terms of individuals expectations of what inflation is!). As a result, he covered all my main points 🙂

However, I will write some additional stuff anyway 😉

One thing I would add is that the annual % change in the CPI does not measure inflation – instead it measures the growth in an index that represents the general price level, over two points in time that are 12 months apart. Inflation itself is the trend rate of growth in the general price level.

It is this trend that the Reserve Bank needs to keep control of, and as a result any way of measuring this trend would be lovely.

Now this does not make the annual % change in the CPI a useless thing to keep track of – it just means that we have to understand what it means when we look at this index. For example, an exogenous increase in petrol prices will increase the CPI suddenly – but this does not imply that it is inflationary. Take this impulse-response graph from a simple (and extremely dodgy) VAR model:

What this shows us is that the initial shock to petrol prices does lead to an increase in annual growth in the CPI. However, over time CPI growth falls below where it would have been (if the shock had not happened) as the higher petrol prices slow domestic economic activity and increases the deflationary impact stemming from the output gap (Note: This is based on post 1996 data – as a result it does not include any of the episodes of cost push based inflation – which is why we get such a strong result).

This tells us that it is important to think about how shocks influence annual growth in the CPI now and in the future, in order to get an idea of true “inflationary pressures”. As a result, we shouldn’t be criticizing the Reserve Bank for the CPI rising at more than 3% right now – but we should be a bit concerned about the fact that the trend in price growth has been on the rise (as that measures the inflation we have been talking about)!

Do you guys think that this way of measuring inflation is consistent – tell me what you think 😉

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5 Responses to "Price indicies: A discussion"

I agree with the sense of what you say. However, I still think the “How do we measure inflation?” is still in need of some help. I think we need a CPI that accurate reflects how prices have increased – that is what most of us are interested in. And I think the current announcements are under-reporting actual inflation.

I also agree that the Fed (and some other economists) would care a great deal about how the price changes already reflected in the economy are going to play out going forward – like your graph shows.

“And I think the current announcements are under-reporting actual inflation”

I think that current announcements over-report actual inflation – insofar as inflation is the trend increase in the general price level, and inflation figures are also capturing a increase in some relative prices. I believe that in the past we have under-reported inflation, because their has been a decrease in some relative prices.

“I think we need a CPI that accurate reflects how prices have increased”

The CPI does accurately reflect how prices have increased for the average household – however, some prices have increased a lot more than others, which implies that some households have experienced a large increase in the cost of their previous consumption bundle, while others haven’t.

There are two questions we want to answer: “what is happening to peoples ability to purchase” and “what is happening to inflation”. We are trying to use the same measure (CPI) to tell us both – and we just have to be weary of its limitations.

[…] No.  I have tried to avoid calling CPI growth inflation because, its not really. […]

[…] with this view – hell we have discussed the ambiguous nature of oil prices on inflation before (here, here, and here).  However, our conclusion was that the net impact would be zero – not the […]

[…] Before criticising the Bank for targeting inflation, the Standard should look at the Bank’s statements and get a feeling for what the Bank terms “inflation” – a place to get a run down on this is here […]

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