Consumer Price Index (CPI) Lecture Notes PDF

Measurement: Consumer Price Index Introduction to Macroeconomics - Winter 2025 1 Jean-Paul Lam January 23, 2025 1 These lecture notes are t...

Measurement: Consumer Price Index Introduction to Macroeconomics - Winter 2025 1 Jean-Paul Lam January 23, 2025 1 These lecture notes are the property of the author. They are intended for the Econ 102 class and can only be used and shared with students registered in the class. You cannot reproduce these notes with the intent of distributing them to anyone not registered in this course or online for and not for profit without my written consent. 1 / 65  Learning objectives In this lecture, we will: I learn about the consumer price index (CPI), other measures of the price level, and the inflation rate I demonstrate how the CPI is constructed and the problems associated with the CPI as a measure of the cost of living I understand how the CPI is used for deflating and indexing series I reinforce the differences between nominal and real values 2 / 65  What is the Consumer Price Index? Price indices measure the average price level, and the most common index you often see in the news is the consumer price index (CPI). In Canada, the CPI, also known as all-items CPI, is computed and published each month 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, through time, the cost of a fixed basket of commodities purchased by Canadian consumers in a particular year. Since the basket contains commodities of unchanging or equivalent quantity and quality, the index reflects only pure price movements.” CPI FAQs 3 / 65  Why is the CPI an important statistics? The CPI is an important economic indicator as it affects Canadians in many different ways: 1 The CPI provides information about price changes to the government, workers, and businesses; these economic agents use the CPI to formulate policy and make decisions 2 The CPI is used by the Bank of Canada to formulate monetary policy, by the government to adjust transfer payments, income-tax brackets and by businesses and the government to provide cost-of-living adjustments to Canadians 3 The CPI 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. 4 / 65  The CPI - November 2024 The latest release of the CPI contains information about the overall price level in Canada during the month of November 2024 CPI November 2024 “The Consumer Price Index (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%.” 5 / 65  The CPI - November 2024 This press release states that the “CPI rose 1.9% on a year-over-year basis in November 2024,” implies that compared to the level of prices the same month the previous year, that is November 2023, the representative basket of goods and services in Canada increased by 1.9%. 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 therefore important to know whether the cost of living is trending up or down over time, as changes in the cost of living affect our purchasing power and the efficient allocation of resources. 6 / 65  A representative basket of 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 thus measures changes in the price of that basket of goods from one period to another. The basket of goods and services is assumed to represent the spending habits of a typical Canadian household. 7 / 65 How is the representative basket of goods and services constructed? The basket is constructed from administrative data and sample surveys carried by Statistics Canada CPI Interactive The basket is regularly updated to reflect changing consumption habits and tastes and also to incorporate the introduction of new products. Information on prices is obtained by conducting surveys from a selection of geographical areas, various stores, and the timing of price collection during the month is predefined. Although the survey is mandatory, the extent and quality of the sample depends on the information available This is why the CPI data is sometimes revised to account for new information, mistakes or new methodology 8 / 65  CPI - 8 categories 1 Food 2 Shelter The basket contains around 700 goods representing the average 3 Household operations and Canadian”s spending habits. furnishings The goods and services in the 4 Clothing and footwear basket of goods are organized 5 Transportation according to a classification 6 Health and personal care system and there are eight 7 Recreation, education and reading categories: 8 Alcoholic beverages and tobacco products 9 / 65  Basket of goods and services Let’s have a look at the representative basket of goods and services There are eight categories in the basket Basket weights 10 / 65  CPI - Shelter category Shelter accounts for the biggest share in the basket (29.15%), followed by transportation (16.9%) and food (16.69%) The shelter category is further divided into: i Owned accommodation, 18.55% (includes replacement costs, property taxes, insurance, home repairs) ii Rent, 7.37% iii Water, fuel, electricity, 3.22% 11 / 65  CPI - Food category For the “Food” category (16.69% of the basket), the share of each good and service also varies within each category Food purchased from stores account for 10.72% and food purchased from restaurants account for 5.97% of the basket For example, 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%) Therefore, changes in the price of meat have a more significant impact on consumers than similar changes in the price of dairy or fish. 12 / 65  The base year To calculate how much prices have increased from one year to another, a base year or period is selected. This base year is chosen by Statistics Canada and 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. 13 / 65  Calculating CPI To illustrate how CPI is calculated, let us assume a rudimentary economy that has three goods; grapes(g), wine(w) and cheese(c). Furthermore, assume that these goods have the following weights in the representative basket of goods are 2 grapes, 3 wines and 4 cheeses. Table: Basket of goods and services Goods and services Quantity Grapes 2 Wine 3 Cheese 4 14 / 65  An example to calculate CPI Table: Prices and quantities in 2023 and 2024 Goods and services Prices in 2023 Prices in 2024 Quantity Grapes 5 6 2 Wine 4 6 3 Cheese 4 5 4 Suppose we want to calculate how much prices have increased between 2023 and 2024 (we set 2023 as the base year at 100) First we calculate the cost of the basket in 2023 = (pg2023 × qg ) + (pw2023 × qw ) + (pc2023 × qc ) = (5 × 2) + (4 × 3) + (4 × 4) = 38 Next we calculate the cost of the basket in 2024 = (pg2024 × qg ) + (pw2024 × qw ) + (pc2024 × qc ) = (6 × 2) + (6 × 3) + (5 × 4) = 50 ! (pg2024 × qg ) + (pw2024 × qw ) + (pc2024 × qc ) CPI2024 = × 100 (pg2023 × qg ) + (pw2023 × qw ) + (pc2023 × qc )   50 = × 100 = 131.5 38 15 / 65  An example to calculate CPI In the above example, the level of the CPI in 2023 (the base year) is 100 and the level of the CPI in 2024 is 131.5 in 20244 This implies that it cost $100 to buy the basket in 2023 and $131.5 in 2024 to buy the same basket Using this information, we can calculate how much CPI has changed from one year to another or the year-over-year change This will give us an indication of how much the basket of goods and services or the average price level has changed over time. The increase in the average price level from one period to another is known as the rate of inflation. 16 / 65  An example to calculate CPI Inflation is therefore defined as the rate at which the average price level is increasing over time. Deflation, on the other hand, is the rate at which the average price level is falling over time Knowing the rate at which prices change over time is vital for economists, as inflation or deflation can substantially affect the economy, even at moderate or low levels. In our example, the rate of change in prices equals 131.5−100
100 × 100 = 31.5% In this economy, the year-over-year rate of inflation in 2024 is thus 31.5%. 17 / 65  The rate of inflation Statistics Canada publishes CPI data every month. Using monthly data, the yearly growth rate of inflation at any time t is calculated as:   CPIt − CPIt−12 × 100 CPIt−12 Where CPIt is the CPI level at time t and CPIt−12 is the CPI level for the same month one year ago 18 / 65  Canada’s rate of inflation, 1970-2024 14 14 12 12 10 10 8 8 Percent 6 6 4 4 2 2 0 0 -2 -2 1970 1976 1982 1988 1994 2000 2006 2012 2018 2024 19 / 65  Inflation rate in Canada Four distinct periods when you look at total CPI: 1 Great inflation of the 1970s 2 Disinflation in the 1980 3 Stable inflation around the Bank of Canada target from the mid-1990s until 2021 4 High and volatile inflation since early 2021 20 / 65  Great inflation of the 1970s Inflation was high and volatile for most of the 1970s Causes? 1 Bad luck and bad shocks F Multiple oil price shocks that led to high energy prices 2 Bad policy because central banks did not aggressively raise the interest rates to fight inflation F Central banks did not understand the role of inflation expectations and their influence on inflation 21 / 65  1980s disinflation Many central banks, including the Bank of Canada, were determined to bring inflation down Paul Volcker in the U.S. was appointed Fed Chairman, and John Crow, Governor of the Bank of Canada Policy became very restrictive in the 1980s and central banks understood better the role of expectations on inflation 22 / 65  Inflation targeting regime since 1991 Since 1991, the Bank of Canada’s main objective has been to target the all-items (or total) CPI inflation between 1%-3%. The Bank of Canada, when setting monetary policy and interest rates, aims to achieve an inflation rate of 2%, the middle of the target band As you can see, since the mid-1990s and until recently, the Bank of Canada has been very successful in keeping inflation around its target Many central bankers thought that we had defeated inflation 23 / 65  Current inflation rate in Canada Since early 2021, inflation in Canada and around the world has made a comeback What might have caused the recent rise in inflation in Canada? 1 Supply constraints and supply-chain issues resulting from Covid 2 Tight labour market 3 Excess demand for goods and services 4 Conflicts in Ukraine and the Middle East are putting pressure on energy, food prices and transportation costs With the rapid increases in interest rates, inflation in Canada has now fallen back to the Bank of Canada’s 2% target 24 / 65  Inflation rate of the Components of the Basket 25 25 20 20 All-items CPI All-items CPI 20 Food 20 15 Shelter 15 15 15 Percent 10 10 10 10 5 5 5 5 0 0 0 0 -5 -5 -5 -5 1970 1983 1996 2009 2022 1970 1983 1996 2009 2022 Year 15 15 20 All-items CPI 20 All-items CPI Transportation Hous operations 10 10 10 10 5 5 0 0 0 0 -10 -10 -5 -5 1970 1983 1996 2009 2022 1970 1983 1996 2009 2022 Source: Statistics Canada, Table: 18-10-0004-01 and author’s calculation 25 / 65  Inflation rate of the Components of the Basket 15 15 15 15 All-items CPI All-items CPI 10 Clothing 10 Healthcare 10 10 Percent 5 5 5 5 0 0 0 0 -5 -5 -10 -10 -5 -5 1970 1983 1996 2009 2022 1970 1983 1996 2009 2022 Year 15 15 30 30 All-items CPI All-items CPI Recreation 20 Alcohol 20 10 10 10 10 5 5 0 0 0 0 -10 -10 -5 -5 -20 -20 1970 1983 1996 2009 2022 1970 1983 1996 2009 2022 Source: Statistics Canada, Table: 18-10-0004-01 and author’s calculation 26 / 65  Real value of money We care about inflation or deflation because both have costs even at moderate levels. Although we will study the costs of inflation and deflation in more detail later in this course, we focus on one particular cost of inflation and deflation in this lecture. Inflation is costly because it erodes the purchasing power of money or the real value of money 27 / 65  The debt-deflation cycle 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. Although deflation leads to an increase in the real value of money, it also leads to a rise in the real value of debt. This, in turn, can lead to a so-called debt-deflation cycle that can be devastating for an economy. To illustrate these points, let us take two examples. 28 / 65  Value of money and relative prices Assume there are 4 goods: apples, oranges, grapes and money. In this economy, money is used to purchase the three other goods. The price of each good simply reflects the amount of money you need to give up (or exchange) to obtain the good. The amount of money or units of money you have to give up to obtain one apple is known as the relative price of apples (relative to money). Each good has a relative price reflecting the amount of money you have to give up to acquire the good. 29 / 65  Value of money and relative prices Thus, in our economy, we have three relative prices, one for each good in terms of money. Assume the following prices: Papples = $2, Poranges = $3, Pgrapes = $1.50. Using money as the numeraire, you can easily calculate the relative price of each good in terms of money and the relative price of each good in terms of each other if needed. For example, in our case, the price of an orange relative to money is $3, and the price of grapes relative to money is $1.50, which implies that the price of oranges relative to grapes is 2. 30 / 65  Purchasing power and relative prices Now suppose apples, oranges and grapes double in price, such that Papples = $4, Poranges = $6, Pgrapes = $3. In this case, relative to money, the price of all fruits has gone up since you have to give up $4, $6 and $3, respectively, to buy apples, oranges and grapes. Since you have to give up more money to buy these goods, this implies that the purchasing power or real value of money has fallen Therefore, the purchasing power or real value of money is inversely related to the price level. 31 / 65  Price level and the real value of money Thus, in general, if we assume N good where the nth good is money, the relative price (RP) of goods N = 1, 2, 3..., n is simply: p1 RP1 = pn p2 RP2 = ,.... pn pn RPn = =1 pn where pN is the price of good N. Hence RPN is the number of units of money that must be given up to acquire one unit of a given good. It is clear that the value of money is the inverse of the price level. 32 / 65  Debt and deflation If rising prices erode the value of money, on the other hand, falling prices mean that the real value of money is increasing. Deflation is a persistent fall in the overall price level For example, in the 1930s, the general price level fell by 20% in Canada and by over 25% in the U.S. Like its counterpart, deflation can also be very costly for an economy as it can lead to a debt-deflation cycle since as prices fall, the real value of debt increases. 33 / 65  Debt and deflation in the 1930s An increase in the real value of the debt depresses the economy since indebted individuals and firms are severely impacted and react by consuming and investing less. This contraction in consumption and investment leads to a fall in output and prices decrease further, causing the real value of debt to increase even more. If the debt-deflation cycle cannot be broken, it can lead to catastrophic results, such as in the 1930s In the U.S., prices fell by about 25%, the unemployment rate reached 25% in 1933, and about 40% of all banks failed during that period. 34 / 65  Why do we need to account for inflation? Inflation is a vital statistic since it tells us how the cost of living is changing over time. Many macroeconomic variables are denoted in nominal terms (such as nominal GDP) and often need to be converted in real terms. For example, workers get paid in nominal terms when they receive their salary. However, what is more important for workers is not how much they are paid in nominal terms but rather the purchasing power or real value of their salary 35 / 65  Why do we need to account for inflation? A nominal variable is calculated using current prices and reflects the current monetary value of that variable A real variable is a nominal variable that accounts for the effects of inflation The real value of a variable is obtained by removing the effect of changes in the price level from the nominal variable 36 / 65  Why do we need to account for inflation? For example, suppose that the salary of workers remains fixed for the next five years, but prices are increasing at the rate of 10% each year. In that case, although nominal wages are not changing, the real wages of workers are being eroded each year by 10%. This implies that if nothing is done, the nominal wages of workers are buying fewer and fewer goods each year, making them worse off. 37 / 65  Inflation targeting and the Bank of Canada The CPI is used by the Bank of Canada, government, businesses and consumers to monitor the economy and to monitor how prices are evolving over time. The Bank of Canada has as its sole objective a target for inflation between 1-3%, and it conducts monetary policy to achieve that target. The CPI is also used by the government to adjust the value of transfer and pension payments such as CPP payments, OAS payments, and the tax brackets The CPI is used by the government and businesses to adjust the nominal wages of workers 38 / 65  Decision making and inflation For example, each year, many workers receive a cost of living adjustment (COLA). This COLA is often based on inflation since the latter reflects how much the cost of living has changed over time. This COLA is needed to compensate workers for the fall in the real value (or purchasing power) of their nominal wages. Many other government transfers are also adjusted for cost of living changes 39 / 65  Real and nominal variables CPI is also used to convert the nominal interest rate to the real rate or to convert any nominal expenditures in real terms. We can use the CPI index to convert many variables in real terms to eliminate the effects of inflation. This is often known as deflating the nominal variables. Deflating implies that we divide the nominal value by the price index to express it in real terms. 40 / 65  Using CPI to deflate Suppose we have the following information about the CPI, nominal wages, and real wages Table: Wages and CPI index in 2023 and 2024 using 2017 as the base year (2017=100 Year CPI Nominal wages Real wages (in 2017 dollars) 100
2023 105 100,000 105 × 100, 000 = 95, 238 100
2024 130 110,000 130 × 110, 000 = 84, 615 Nominal wages increased by 10% from 2023 to 2024 However, real wages in 2024 are below their 2023 level by 11.15% This implies that prices have increased at a faster rate than nominal income. Since prices between 2023 and 2024 increased by 23.8%, to keep real wages at their 2023 level, nominal wages in 2024 should also increase by the same amount as prices, that is, by 23.8% to $123,809 41 / 65  Using CPI to index Inflation is also used for indexing purposes. Certain types of expenditures and payments are often adjusted each year to reflect the changes in inflation. For example, pension benefits may be indexed at the rate of inflation. Thus, if the rate of inflation is 2% per year, pension benefits may be indexed by the same amount; that is, they would also see an increase of the same amount in nominal terms every year. 42 / 65  Indexing -example As an example, assume that pension benefits are indexed to inflation each year. Pensions in nominal terms are adjusted to reflect increases in the cost of living. Assume the following information: Table: Pension benefits indexed for inflation Pension in 2017 (CPI=100) CPI2022 CPI2023 CPI2024 10,000 105 111 129 43 / 65  Indexing -example The pension benefit must be adjusted to reflect the changes in inflation each year. If the CPI =100 in 2017:   105 − 100 Inflation in 2022 = × 100 = 5% 100   111 − 105 Inflation in 2023 = × 100 = 5.71% 105   129 − 111 Inflation in 2024 = × 100 = 16.22% 111 Based on the above, this implies that the pension benefits should be: Pension in 2022 = 1.05 × 10, 000 = 10, 500 Pension in 2023 = 1.0571 × 10, 500 = 11, 099 Pension in 2024 = 1.1622 × 11, 099 = 12, 899 44 / 65  Real and nominal rate The CPI is often used to “deflate” the nominal interest rate to obtain the real interest rate. The nominal interest rate is the payment one receives on the initial investment, expressed as a percentage. For example, if someone buys a Canadian savings bond for $1000 today and then cashes it for $1100 one year later, the annual interest payment on the bond is 1100−1000
1000 x100 = 10%. 45 / 65  Real and nominal rate However, what matters is not what the bond pays in nominal terms (the nominal interest rate) but rather the yield on the bond in real terms (the real interest rate), that is, the returns after accounting for inflation Assume that the average price level increases by 10% the same year. Thus, although the bondholders are better off in nominal terms, they are not in real terms since the price of goods and services also increased by 10%. In other words, inflation has eroded the purchasing power of the nominal return on the bond 46 / 65  The Fisher equation The real interest rate thus measures the return one obtains on the bond after accounting for inflation. The real and nominal interest rate is related to each other by the Fisher equation (after Irving Fisher). Denoting the nominal interest rate by i, the real rate by r and the inflation rate by π, we obtain: r =i −π (1) Investment, savings and lending decisions are all influenced by the real and not the nominal rate. 47 / 65 Implications of inflation for savings and investment and the Bank of Canada We know that high inflation erodes the purchasing power of nominal returns on savings Sometimes high inflation can lead to negative returns in purchasing power or in real terms, discouraging savings On the other hand, periods of low inflation increase the real value of savings and can encourage people to save more We will learn later in the course that the Bank of Canada adjusts the nominal interest rates to control inflation and stabilize the economy. 48 / 65  Problems with the CPI The CPI is based on a representative basket of goods that relies on a basket of goods or services to calculate how much prices have changed from one period to another That is, the quantity and quality of the goods included in the basket of goods are assumed to be fixed over time. Assuming that the basket of goods is fixed over time is one of the significant problems associated with the way the CPI is computed. Although the basket is updated periodically, it does not reflect improvement or changes in the quality of goods or changes in agents’ tastes and preferences. 49 / 65  Problems with CPI - Improvements in quality As new technology or models are introduced, the quality of goods in the real world can rapidly change. For example, every couple of months, the quality (and speed) of computers and smartphones change. Tastes and preferences of consumers also change. Although the CPI treats the basket of goods and services as fixed, the basket itself, in reality, is changing. Improvements in the quality of goods and changes in tastes and preferences are not appropriately reflected in the calculation of CPI. 50 / 65  Problems with CPI - Improvements in quality The price of cell phones has risen over time, especially after the introduction of smartphones. At the same time, we have also witnessed significant changes in the technology of smartphones. Phones are now faster, and you can do a lot more on your phone than 5 years ago. How is this taken into account when the CPI is calculated? 51 / 65  Problems with CPI - ignore improvements The CPI reflects the increase in prices but fails to reflect the increase in the quality/speed of smartphones if the basket is not updated. One may conclude that consumers are worse-off based solely on the increase in the price of smartphones However, comparing the prices of smartphones based on the CPI ignores the fact that quality has also drastically improved over time. These improvements in quality benefit consumers but are not correctly reflected in the basket of goods As a result, the CPI will over-estimate the actual change in prices of cell phones 52 / 65  Problems with CPI - Substitution bias Another problem with the fixed basket of goods is that it fails to capture substitutions within the basket For example, if beef prices increase, consumers substitute chicken for beef and, therefore, consume more chicken and less beef. Ceteris paribus, the CPI will reflect the changes in the price of beef and will indicate that the cost of living has increased. Based on this information, one may conclude that consumers are worse off. However, this is not necessarily the case, as consumers have adapted to the increase in the price of beef by substituting chicken for beef. 53 / 65  Problems with CPI - sample Since the CPI ignores quality improvements and substitutions within the basket, it tends to overstate the actual cost of living. There are other reasons why economists believe that the CPI overstates the actual cost of living. For example, when data on prices are collected, the sample prices are obtained only from a sample of stores. Often, the sample of stores does not include discount stores. Discount stores often have lower prices for the same products sold in supermarkets Since the CPI survey excludes many of these discount stores, it will not capture that prices for some goods are lower than indicated in the survey 54 / 65  CPI and GDP deflator Measuring changes in the price level using the CPI is imperfect. Fortunately, there exist some other measures of the price index. We have seen in the previous lecture that one of them is the GDP deflator. Recall the GDP deflator is the ratio of nominal to real GDP. The CPI and GDP deflator give different information about the overall price level in the economy. 55 / 65  Differences between the CPI and GDP deflator The CPI measures the change in the price level of a fixed basket of goods and services over time in Canada On the other hand, the GDP deflator measures the change in the price level of all goods and services produced at a given time in Canada Thus, the GDP deflator includes the prices of more goods and services than the CPI and gives a broader picture of what is happening to the price of goods and services bought by consumers. For this reason, many economists argue that it is a better measure of the cost of living. 56 / 65  Differences between the CPI and GDP deflator A second difference is that the GDP deflator measures the price of goods and services produced domestically, whereas the CPI includes the price of imported goods also. Hence, changes in the price of foreign goods affect the CPI and not the GDP deflator. For an economy that consumes many imported goods, it is clear that the GDP deflator may understate the cost of living. 57 / 65  Differences between the CPI and GDP deflator The third difference concerns how these two measures assign weights to the prices of different goods and services. The CPI, as we have seen, assigns fixed weights to the goods and services in the basket over time — the basket does not change over time The GDP deflator assign different weights to the goods and services produced Economists call a price index with a fixed basket of goods a Laspeyres index and a price index with a changing basket a Paasche index. The Fisher-price index lies between the two indices as it is the geometric average of the Laspeyres and Paasche indices Both the Laspeyres and Paasche indices are not perfect and have their drawbacks. 58 / 65  Differences between the CPI and GDP deflator For example, if a major frost destroys apple trees and the quantity of apples produced falls to zero, this will drive the price of the existing apples left on the market up significantly. The CPI will show a sharp increase in prices, whereas the GDP deflator will not since the output of apples is now zero and thus does not enter GDP. Therefore, the CPI index overstates the impact of the increase in the price of apples on consumers since it ignores the ability of consumers to substitute for other foods. On the other hand, the GDP deflator understates the actual impact of the increase in the price of apples because the rise in prices makes consumers worse off (especially those who cannot substitute). 59 / 65  All-items CPI and GDP deflator 20 20 All-items CPI GDP Deflator 15 15 10 10 Percent 5 5 0 0 -5 -5 1970 1976 1982 1988 1994 2000 2006 2012 2018 2024 Year Source: Statistics Canada, Table: 18-10-0004-01, Table: 36-10-0106-01 and author’s calculation 60 / 65  Core inflation As we showed, some components of the CPI are very volatile, that is the price of these components vary significantly from one period to another The Bank of Canada and policy-makers are more interested in the trend of prices instead of the month-to-month changes in prices Statistics Canada computes some indices of prices that exclude the movement in prices of volatile components of the CPI; these indices are known as core CPI Core CPI gives us a better picture of the long-run trend of the price level compared to all-items or total CPI 61 / 65  Core inflation as a measure of underlying inflation Core CPI is important as the Bank of Canada does not always want to react to transitory and temporary changes in prices but rather to where prices are moving over time; Reacting to transitory and volatile movements in prices may lead to frequent policy reversals and mistakes The all-items CPI is more volatile than measures of core inflation If the Bank of Canada reacts to all the volatile movements in all-items CPI, it would have to move interest rates much more frequently. The Bank of Canada prefers measures of core inflation when deciding how policy is set because these measures “look through” the temporary change in prices 62 / 65  How is core inflation measure? Statistics Canada computes three measures of core inflation that the Bank of Canada uses for policy decisions: 1 CPI-trim: “CPI-trim is a measure of core inflation that excludes CPI components whose rates of change in a given month are located in the tails of the distribution of price changes.” 2 CPI-common: “CPI-common is a measure of core inflation that tracks common price changes across categories in the CPI basket.” 3 CPI-median: “CPI-median is a measure of core inflation corresponding to the price change located at the 50th percentile (in terms of the CPI basket weights) of the distribution of price changes in a given month. ” 63 / 65  All-items and Core CPI 9 9 CPI Common 8 CPI Trim 8 CPI Median 7 All Items CPI 7 6 6 5 5 Percent 4 4 3 3 2 2 1 1 0 0 -1 -1 2000 2004 2008 2012 2016 2020 2024 Year Source: Statistics Canada, Table: 18-10-0004-01, Table: 18-10-0256-01 and author’s calculation 64 / 65  Conclusion and recap Statistics Canada calculates and publishes the CPI data every month The CPI is a critical statistic that reflects changes in the cost of living. It is used by Statistics Canada, the Bank of Canada, the government, businesses and individuals in Canada for many purposes Monetary and fiscal policies, COLAs, indexing and deflating are often based on the CPI The CPI as a measure of the cost of living has many problems The Bank of Canada focuses on core inflation to set policy 65 / 65