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• This lecture discusses:
  • How the Consumer Price Index (CPI) is constructed.
  • Problems with the CPI as a measure of the cost of living.
  • How the CPI is used for deflating and indexing series.
  • The differences between nominal and real values.

Consumer Price Index Overview

• Price indices measure the average price level; the CPI is the most common index.
• In Canada, the CPI, also known as all-items CPI, is computed and published monthly by Statistics Canada.
• Statistics Canada defines the CPI as "an indicator of the changes in consumer prices experienced by Canadians."
• It is obtained by comparing the cost of a fixed basket of commodities purchased by Canadian consumers in a particular year over time and reflects only pure price movements.
• The CPI is an important economic indicator that provides information about price changes to the government, workers, and businesses.
• Economic agents use the CPI to formulate policy and make decisions.
• The Bank of Canada uses the CPI to formulate monetary policy.
• Used by the government to adjust:
  • Transfer payments.
  • Income-tax brackets.
• Used by businesses and the government to provide cost-of-living adjustments to Canadians.
• It is used to deflate many economic series such as the national accounts, retail sales, and hourly earnings.
• Computing the real value of these series allows economists to study how they have changed over time independently of price movements.
• In November 2024, latest CPI release information included the overall price level in Canada.
• The CPI rose 1.9% on a year-over-year basis in November, down from a 2.0% increase in October.
• Slower price growth was broad-based, with prices for travel tours and the mortgage interest cost index contributing the most to the deceleration.
• Excluding gasoline, the all-items CPI rose 2.0% in November, following a 2.2% gain in October.
• On a monthly basis, the CPI was unchanged in November, following a 0.4% increase in October.
• On a seasonally adjusted monthly basis, the CPI rose 0.1%.
• The CPI rose 1.9% on a year-over-year basis in November 2024, implying that the representative basket of goods and services in Canada increased by 1.9% compared to November 2023.
• It costs Canadians 1.9% on average more to buy the same basket of goods and services in November 2024 compared to November 2023.
• It is important to know whether the cost of living is trending up or down over time, as changes in the cost of living affect purchasing power and the efficient allocation of resources.

Goods and Services

• Since the economy is comprised of millions of goods and services, Statistics Canada (or any other agencies in other countries) cannot monitor the prices of all goods and services.
• Despite being called all-items CPI, the CPI reflects the change in prices of a representative basket of goods and services
• The all-items CPI measures changes in the price of the basket of goods from one period to another.
• The basket of goods and services represents the spending habits of a typical Canadian household.
• Constructed from administrative data and sample surveys carried by Statistics Canada.
• The basket is regularly updated to reflect:
  • Changing Consumption habits and tastes.
  • The introduction of new products.
• Information on prices are obtained by conducting surveys from a selection of:
  • Geographical areas.
  • Various stores.
  • The timing of price collection during the month is predefined.
• The survey is mandatory, but the extent and quality of the sample depends on the information available
• CPI data is sometimes revised to account for new information, mistakes or new methodology
• There are eight categories in the CPI basket totaling around 700 goods and services reflecting the average Canadian's spending habits:
  • Food.
  • Shelter.
  • Household operations and furnishings.
  • Clothing and footwear.
  • Transportation.
  • Health and personal care.
  • Recreation, education, and reading.
  • Alcoholic beverages and tobacco products.

CPI and Shelter

• Shelter accounts for the biggest share in the basket (29.15%).
• Transportation is second at 16.9%.
• Food comprises 16.69% of the basket.
• The shelter category is further divided into:
  • Owned accommodation, 18.55% (includes replacement costs, property taxes, insurance, home repairs).
  • Rent, 7.37%.
  • Water, fuel, electricity, 3.22%.
• For the "Food" category (16.69% of the basket), each goods share varies.
• Food purchased from stores accounts for 10.72%, and from restaurants accounts for 5.97% of the basket.
• In the food purchased from stores, meat (1.94%) has a more important weight than dairy products and eggs (1.47%), which in turn has a bigger weight than fish and seafood (0.37%).

The Base Year

• To calculate how much prices have increased a base year or period is selected.
• Statistics Canada chooses this base year, and it reflects typical economic conditions where the consumption basket represents stable and normal consumer behaviour.
• Years with anomalies like recessions or other extreme economic events are avoided.
• The base year is periodically updated (every 5 years) to capture changes in consumer preferences and technological advancements.

Calculating the CPI with Fixed Weights

• For instance, in a rudimentary economy with three goods: grapes (g), wine (w), and cheese (c), the following is the calculation.
• Assume the basket of goods are:
  • 2 grapes.
  • 3 wines.
  • 4 cheeses.
• Prices and quantities in 2023 and 2024.

• To calculate how much prices have increased, with setting 2023 as the base year to 100 proceed as follows:
  • calculate the cost of the basket in 2023 = (p2023 × qg) + (p2023 x qw) + (p2023 x qc) = (5 x 2) + (4 × 3) + (4 × 4) = 38.
  • next calculate the cost of the basket in 2024 = (p2024 × 9g) + (p2024 × qw) + (p2024 × qc) = (6 × 2) + (6 × 3) + (5 × 4) = 50. CPI2024 = ((p2024 x 9g) + (p2024 × qw) + (p2024 × qc)) / ((p2023 × qg) + (p2023 × qw) + (p2023 x qc)) × 100 = 50/38 × 100 = 131.5
• In this example, the level of the CPI in 2023 (the base year) is 100.
• The level of the CPI in 2024 is 131.5.
• $100 buys the basket in 2023, and $131.5 in 2024 to buy the same basket.
• Inflation can be determined from the year-over-year change.

Inflation

• An indication how much the basket of goods and services or the average price level has changed over time is measurable.
• The increase from one period to another is the rate of inflation.
• Inflation is the rate at which the average price level is increasing.
• Deflation is the rate at which the average price level is falling.
• Knowing the rate at which prices change is vital for economists.
• Formula for the rate of change in prices example in 2024: ((131.5-100) / 100) × 100 = 31.5%.
• The year-over-year rate of inflation example in 2024 is therefore 31.5%.
• Statistics Canada publishes CPI data every month.
• The yearly growth rate of inflation at any time t is: (CPIt - CPIt-12) / CPIt-12 x 100.
• CPIt = the CPI level at time t
• CPIt-12 = the CPI level for the same month one year ago.

Inflation Rates in Canada

• CPI can be viewed across four distinct periods:
  • The Great Inflation of the 1970s.
    • High and volatile.
    • Multiple oil price shocks led to high energy prices.
    • Central banks did not aggressively raise interest rates to fight inflation.
    • Central banks did not understand the role of inflation expectations and their influence on inflation.
  • The Disinflation of the 1980s.
    • Banks, including the Bank of Canada, wanted to bring inflation down.
    • Paul Volcker was appointed Fed Chairman, and John Crow, Governor of the Bank of Canada.
    • Central banks understood better the role of expectations on inflation and became very restrictive.
  • Stable inflation around the Bank of Canada target from the mid-1990s until 2021.
    • The Bank of Canada targeted all-items (or total) CPI inflation between 1%-3% since 1991.
    • To achieve an inflation rate of 2%, the Bank of Canada sets monetary policy and interest rates.
  • High and volatile inflation since early 2021.
    • Possible causes of recent rise in inflation:
      • Supply constraints and supply-chain issues related to Covid.
      • Tight labor market.
      • Excess demand for goods and services.
      • Conflicts in Ukraine and the Middle East affecting energy, food and transportation costs.
    • Inflation has fallen back to the Bank of Canada's 2% target with the rapid increase in interest rates.

Real Value of Money

• Inflation and deflation have costs, even at moderate levels.
• Inflation erodes the purchasing power of money or the real value of money
• The higher inflation is, the more significant is the fall in the purchasing power of money.
• However, when there is deflation, the purchasing power of money increases.
• Deflation leads to a rise in the real value of debt.
• This can lead to a debt-deflation cycle that can be devastating for an economy.
• Relative prices and how value of money plays a role:
  • If there are 4 goods: apples, oranges, grapes, and money, the cost of each good will involve the amount of money you need to exchange.
  • The amount of money (or units of money) is the relative price of an apple relative to money to obtain an apple.
  • Each good has a relative price reflecting the amount of money you give up to acquire the good.
  • Three relative prices, one for each good in terms of money in the economy:
    • Papples
    • Poranges
    • Pgrapes.
  • If using money as the numeraire helps calculate the relative price of each good.
  • With oranges relative to money at $3 and grapes at $1.50, the price ratio implies oranges are 2 relative to grapes.
• Purchasing power falls when prices rise:
  • If Papples = $4, Poranges = $6 and Pgrapes = $3, the price of all fruits has gone up relative to money as you have to give up $3 and $6 respectively to buy things.
  • This purchasing power is related to the price level.
  • With general (N) goods and where the nth good is the price of money (pN) is a generic form for stating the real price:
    • RP1 = p1/ pn
    • RP2 = p2/ pn ....
    • RPn = pn/ pn = 1
    • Where pN is the price of good N.
    • RN is how much money must be exchanged for one unit of one item.
• Deflation can also be very costly as prices fall, and can lead to a debt-deflation cycle, while real value of debt increases
  • Rising prices erode the value of money, on the other hand, falling prices mean that the real value of money is rising, for example, in the 1930s, the level fell by 25% in the US.

Debt and Deflation

• A contraction in consumption during deflation and investment causes output to fall while the real value of the debt continues to increase.
• If the debt-deflation cycle cannot be broken, it can lead to catastrophic results.
• For example, in the U.S. during the great depression:
  • Prices fell by 25%.
  • Unemployment reached 25% in 1933.
  • 40% of all banks failed.
• Many macroeconomic variables are denoted in nominal terms (such as nominal GDP) and often need to be converted in real terms to account for inflation and changing living costs.
• Nominal variables uses current prices and reflect how changes in monetary value affects something, like GDP.
• Real variables are nominal variables that can account for inflation by removing its impacts to the real value.

Accounting for Inflation

• In the case where wages remained fixed for the last 5 years:
  • The real wages of workers are eroded by 10% resulting in buying goods at a deficit to where they started.
  • The government accounts for this through policies and wage adjustments.
• The CPI usage:
  • Government.
  • Bank of Canada.
  • Businesses and households.
• All monitor the economy, how prices change, adjusting government transfers.
• The Bank of Canada targets:
  • Solely between 1-3% in Canada
  • Uses the CPI as a reference for monetary policy achievement
• Collective Bargaining & Inflation:
  • COLA (Cost of Living Adjustments) is often based on inflation data.
  • It aids the decrease in value of nominal wages. Deflation can affect indexing practices.

Conversion and Deflation

• Nominal exchange rate is converted into real terms by eliminating effects of inflation through the following steps:
  • Variables can be converted in real terms using the CPI.
  • Deflating the impact through dividing values by the price index by the price index
  • This is what it would equal in the base year.
• Example scenario with CPI, wages and deflation
• If 2017 is base year in 2023 you made $100,000 but 2017 CPI shows a higher relative purchasing power while a $110,000 earned in 2024 at 130 index results in a fall in real wages of -11.15 % ,
• Prices have increased at faster rate than wages.
• If between 2023-2024 products amount to 23.8% it takes a salary of ~ $124,000 to keep pace.
• Indexing is adjusting expenditures to reflect changes in inflation via rates, pension plans at similar rates with adjustments in nominal terms.
• Example given pension plans are indexed to inflation annually:

• This would mean the following:
  • 2022 = 10,500
  • 2023 = 11,099
  • 2024 = 12,899
• Real vs nominal rates and how they relate:
  • Bonds cashed after their annual premium (I.e 1000 ->1,100) equate a 10 % premium. This payment that is received on the initial investment is nominal.
  • Real Rate are returns after inflation, meaning if the average level increases 10 % what the bond pays in real terms.
  • Even though one is better term you may not see the effect in real terms.

Fisher Equation

• Illustrates the Real Rate
• Formula, investment savings are influenced by real rates.
• r=i-π

Bank of Canada

Adjusts based on interest rates, savings can lead to negative returns and control, and stabilize the economy.

Issues

• The is measured through goods and services prices that rely on measuring cost changes:
  • Quantity doesn't accurately adjust to changing prices.
  • Quality changes when goods improve
  • Tasters and preferences don always remain constant with consumer bases.
• Example:* Smartphones get cheap but fast that aren't accounted for .
• Consumers also react by spending.
• CPI reflects that as basket doesn't get it right.
• In the end CP over estimates changes in phone prices.
• The CPI does capture substitutions, changes from chicken instead of Beef when consumers pay more for chicken. But as the fixed basket, in the CPI, there is only so much.
• Collection also only involves shops with discount ones never recorded.

CPI vs GDP

• CPI is calculated based on a basket while GDP is all prices and goods.
• Better as it includes abroad while CPI is in Canada so what's produced domestically changes prices.
• Weights also differs. CP uses fixed, the GDP assign different weights based on production .
• Laspeyres vs pasche difference and how it effects consumers to change or be hurt for not substitution.
• This effects how they get measured over time.

Core Inflation

• CP fluctuates and the volatility affects the price of the components that deviate from others. The Bank policy makers focuses on trend to trend changes. So statistics Canada calculates them.
• Aids a full picture compared to the general and policy change the banks focus on, and set measures that look through them. CPI measures are:
  • CPI Trim
  • CPI common
  • CPI median