Inflation

Inflation is commonly understood to mean a rise in the general level of prices. Statistics New Zealand (SNZ) compiles a number of different measures of how prices have changed. Each has a different use. Some understanding of the differences and how to decide which measure is appropriate in a particular situation is useful in making many business decisions.

Why measure price changes?

There are a number of reasons why people might be interested in changes in price over time. Some of the most common are:

• To enable changes in the quantity of expenditure to be distinguished from changes in the value of expenditure. If the dollar value of paper clips bought rose from $5 to $10 it would be useful to know how much of this was a due to a change in the price of paper clips, and how much was due to a change in the quantity purchased. The price series used to convert values into volumes is often referred to as a deflator.

• For the indexation of contracts. A number of contracts have a clause that ties changes in payments to changes in prices. This is common in business supply agreements and wage contracts. Some social welfare benefits are also linked to inflation. Indexation protects the real value of a contract. For example, a change in an employee’s wages in line with inflation maintains the purchasing power of those wages.

• Prices are economic signals to producers, and can indicate which sectors are more profitable. Differences in price movements between sectors or industries can result in structural shifts in the economy. Information about prices is therefore an important element in the efficient functioning of a market economy.

• Changes in prices are interesting in their own right. For example examining price changes can allow an assessment of the extent to which price changes are absorbed, exported and passed on at different points in the distribution chain.

How do we measure price changes?

A number of measures of price change are compiled by SNZ. A basket of goods is selected to represent either the purchasing patterns of a particular group, or the economy wide purchases of a particular type of product in a given period. The prices of goods in the basket are collected over time, usually quarterly but sometimes more frequently.

Prices are usually presented as an index. In the base period, the index is set at 1000. A price index gives information only about changes in the price level, not about the absolute level of prices at any particular point in time. A single point in a price index has no meaning (this is true of any index).

The goods in the basket that comprise an index do not change between periods, so changes in the index are solely a result of changes in price.

What do we measure the price of?

Some of the measures of price changes compiled by SNZ are discussed below. It is important when a price index is used to deflate the value of some expenditure that the basket of the index selected matches the products being deflated as closely as possible.

The consumers price index (CPI) is probably the most commonly quoted measure of price change in the NewZealand economy. The CPI measures changes in the price of the basket of goods bought by an average household. The basket is based on expenditure patterns recorded in the 1997/98 Household Economic Survey. It explicitly excludes interest rates.

The CPI is the benchmark for measuring the purchasing power of household income. It is appropriate to use the CPI to index a contract or as a deflator where the expenditure items relate to household spending. The CPI is also the measure of inflation targeted by the Reserve Bank.

There are two producers price indexes (PPI). The input index measures the price of goods and services used in the production of other goods and services (i.e. the price of intermediate consumption). The price of capital and labour is excluded from the PPI input measure. The output price index measures the price received by businesses for goods and services produced (i.e. the price of gross output).

Whereas the CPI measures price changes affecting the household sector of the economy, the PPIs measure price changes in the productive sector of the economy. PPI indexes are available for each industry in the NewZealand economy based on ANZSIC industry groupings.

Separate indexes are available for capital or labour prices. The capital goods price index (CGPI) measures changes in the price of physical capital assets purchased in NewZealand. Large non-recurring items (such as a frigate) and second hand assets are excluded from the basket. The labour cost index (LCI) measures movements in base salary and ordinary time wages as well as overtime wages and a number of other non-wage labour related costs (for example annual leave and ACC premiums).

Although they each measure an aspect of business’ input costs, changes in the PPI inputs, CGPI and LCI can be quite different. In the calendar year 2000, the PPI inputs rose 10.2%, the CGPI rose 4.8% and the wages and salaries component of the LCI rose 1.6%. Hence, care should be taken in business agreements about the basis for any adjustment for changes in input costs. The result can vary depending on the choice of index, and can result in a windfall gain (or loss) if the wrong index is selected.

So far we have dealt with prices of goods traded within NewZealand. SNZ also compiles an export price index and an import price index. Indexes are available for merchandise and services. These indexes are used to deflate the value of exports and imports. They can also be combined in a measure of the purchasing power of our exports overseas (called the terms of trade); this is simply the export price index divided by the import price index.