Measuring the Cost of Living - Chapter 25

Inflation - a rise of average prices through the economy.

- it means that money is losing its value.

Deflation - the flip-side of inflation.

• average prices are falling
• various economic effects – spending is delayed if expectation prices
will fall.
• sustained deflation can cause a rapid economic slow-down.
Deflationary periods in New Zealand history

Brief periods of
deflation in the past
150-odd years,
associated with
economic depressions.
The Consumer Price Index (CPI )
- measures the overall cost of a “basket” goods and services bought
by a typical household.
- it measures the rate of price change of goods and services
purchased by households.

• The CPI measures changing purchasing cost a fixed basket of goods and
services

• Basket represents the average expenditure pattern of New Zealand

households at the index base period.

• The “basket” reviewed every three years - household spending patterns

change over time
The CPI is used as :
• a measure of inflation
• indicator for monitoring economic and monetary policy
• indicator of the effect of price change on the purchasing power
of households' incomes
• means to adjust benefits, allowances and incomes
• as a price deflator.

The CPI all groups index is prepared quarterly.

The food group of the CPI is prepared each month.

Constructing the CPI – a simple example

Simple economy - only two goods consumed

- a “basket” consisting of 2 pizzas & 4 songs
Year Price of songs Price of pizzas
2018 $2.20 $7.00
2019 $2.50 $9.00
2020 $3.00 $11.00

Year Cost of basket

2018 ($2.20 x 4) + ($7.00 x 2) = $22.80
2019 ($2.50 x 4) + ($9.00 x 2) = $28.00
2020 ($3.00 x 4) + ($11.00 x 2) = $34.00
Selecting a base year of 2018, the CPI for each year is :

Year CPI
2018 $22.80 / $22.80 x 1000 = 1000
2017 $28.00 / $22.80 x 1000 = 1230
2020 $34.00 / $22.80 x 1000 = 1490

Year Inflation
2019 (1230 – 1000) /1000 x 100 = 23%
2020 (1490 - 1230) /1230 x 100 = 21%
All Groups CPI

See:
Consumers price in
dex review: 2014
Uses for the CPI

• measure of aggregate price level in the economy.

• measure change in the cost of living.

• to estimate how much income needs to raise to maintain a constant

standard of living

• to evaluate how much standard of living has eroded.

Problems with the CPI

Substitution bias

• not all prices raise proportionately – some raise more than others and
some even fall

• consumers substitute to goods & services that are relatively cheaper

• As a result the index will overstate increases in the cost of living

Introduction of new goods
• increase variety of goods consumed – rendering each dollar more valuable
• should show as a decrease in the index due to greater purchasing power of
each dollar
• subsequent index calculation take into account changes in price of such
items - but impact at introduction is not incorporated eg tablets

Unmeasured quality changes

• quality of a good or service raises then the value of each dollar raises
• quality of a good or service falls then the value of each dollar falls
• while the price of a good/service can be adjusted in the face of changes in
quality such changes are hard to measure.
Comparing eras
Min wage 2001 = $7.70 CPI = 687 Min wage 2020 = $20.00 CPI = 1068

Min wage from 2000 = 7.70 x (1068/687) = $11.97 in year 2020 dollars
Min wage from 2015 = $20.00 x (687/1068) = $12.86 in year 2000 dollars

Indexation

Correction for inflation by law or contract - indexed for inflation

e.g maybe built into a contract award , carried out for benefits & pensions

Inflation Calculator at http://www.rbnz.govt.nz/monetary_policy/inflation_calculator

 The Fisher effect – Real vs Nominal Interest

Consider: a $100 deposit in a bank earning 10% per anum wiil give $10 in interest.

However inflation is running at 4%. How much is the gain really?

To keep up with inflation $104 is required by the end of the year to simply maintain
purchasing power.

So in “real terms” only $6 is gained.

Real interest rate = Nominal interest rate - Inflation rate r=R-π

Rearranging this equation: R=r+π

Consider : Nominal interest rate = 9% Inflation rate = 6%

Then the real interest rate, R = 9 – 6 = 3%

Tend to see nominal interest rates moving with inflation.

https://www.rateinflation.com/consumer-price-index/new-
zealand-historical-cpi/
But unexpected inflation is an issue.

Example (Arbitrary redistribution of wealth)

A loan of $10,000 to be repaid in five years plus interest costs of $5,000 thus total
repayment is $15,000

If your salary rises with inflation, your $15,000 repayment as a proportion of your salary will
depend on the inflation rate:
 If inflation, you will repay the loan with less valuable dollars
 If deflation, you will repay the loan with more valuable dollars
CPI inflation averaged
around 12% in the
1970s and 11% in the
1980s.

Since September 2002,

the inflation target
within a range of 1-3 per
cent on average over the
medium-term.

Since 2000, CPI inflation

has averaged around
2.7%.

New Historical Data https://www.statista.com/statistics/375265/inflation-rate-in-new-zealand/

Inflationary Events
Inflation since 2000
Under the current Policy
Targets Agreement (PTA) the
RBNZ is required to keep
annual increases in the CPI
between 1 and 3 percent on
average over the medium
term, with a focus on keeping
future average inflation near
the 2 percent target midpoint.

Link to Policy target Agreement

2018