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hi
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i'm stefano from the rba in this video
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which is part of our series of videos on
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inflation i will talk about how cpi
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inflation is calculated
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links to the other videos in the series
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are provided in the description
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in the introduction video we saw that
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inflation is generally defined as an
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increase in the prices of goods and
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services in the economy
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the most well-known way to measure
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inflation is a consumer price index or
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cpi
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which measures the percentage change in
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the price of a basket of goods and
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services
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purchased by the average household
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in australia the cpi is calculated by
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the australian bureau of statistics
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the abs to understand how inflation is
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calculated
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the first question is how does the abs
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choose the items in the cpi basket
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for this the abs uses information about
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the way the average
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household in australia spends its income
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the abs looks at
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what items households spend their money
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on and how much
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they spend on each item for example
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think about rent clothes movie tickets
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and many other goods and services and
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the amount of money
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that households spend on these based on
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this information
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the abs selects the goods and services
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to include in the basket
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and what their weight should be the
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weight
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is the importance of each item in the
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basket and it reflects the share of
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household income
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spent on that item for example if
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households spend
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more of their income on rents then rents
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will have a larger
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weight in the cpi basket we will see
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shortly an example
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of how these weights are used in total
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the abs
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collects around 100 000 prices each
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quarter from a wide range of sources
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including retailers supermarkets
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department stores and websites
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government authorities real estate
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agents and many more
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these thousands of items are included in
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11 high-level groups
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which represent the areas where
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australian households spend their income
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currently the largest group is housing
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which includes items like
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rent payments and electricity bills this
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group represents almost
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one quarter of what the average
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household spends in australia
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and that is its weight in the cpi basket
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the other groups represent progressively
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smaller shares of household spending
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for example food and transport all the
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way down to communication
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which include includes things like your
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mobile phone bills
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you may find it difficult to match this
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breakdown with the expenditures of your
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own
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household it is important to remember
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that these are average numbers
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and that each household will be
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different for example
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the number of people in the household
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their age and where they live
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with all this in mind we need a simple
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example to understand
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how the abs puts all these price changes
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together
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to calculate cpi inflation imagine an
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economy where households buy only two
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items
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a book and one hour of child care
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services
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these two items will be the cpi basket
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in our economy
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let's assume that in 2018 the price of a
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book was 20
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and the price for one hour of child care
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was 30
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in a simple example then the average
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household spent a total of 50
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in 2018. 60 of this
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30 is spent on child care and
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percent twenty dollars on books so sixty
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percent and forty percent
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are the shares or weights for these
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items in the cpi basket for our economy
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now let's assume that one year later in
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2019
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prices have gone up for both items
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we can easily calculate the growth of
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prices for the two items
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one year to the next and we can get
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annual
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inflation of 2.5 percent for books
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and 4.7 percent for child care
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to calculate a weighted average
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inflation rate for our basket
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we simply multiply each of the weights
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by the inflation rate for the
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corresponding item
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and add together the results for our
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simple economy
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we obtain an annual cpi inflation of 3.8
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because of the weights used in the cpi
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calculation price changes for the
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items on which households spend more
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money
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in this case child care will be more
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important
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that for the final result hence why the
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inflation rate for our economy
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is closer to 4.7 percent than 2.5
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percent
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for the australian economy every quarter
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the abs
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tracks price changes for thousands of
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items in the basket
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and uses their weights to calculate cpi
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inflation
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using a similar method to the one just
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explained
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to check out prices of goods and
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services across the australian
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cpi basket have changed over time there
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is a tool on the rba website called the
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inflation explorer
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you can use it for information on all
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categories in the cpi basket
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as well as for the basket as a whole it
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also allows you to compare price changes
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of multiple items
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against each other for example
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thinking about our book prices from
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earlier on we can use the explorer to
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check what happened to prices of books
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in australia between
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2015 and 2019 as in the screenshot
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provided here
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a link to the explorer is included in
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the description
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now that we've looked at calculating
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inflation for a basket of goods and
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services
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it's important to consider some
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limitations of the cpi calculation
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in this video i will only give a high
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level overview
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we will look at the things that cpi does
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not measure
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the consequences of the cpi basket being
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updated only annually
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and we will consider the impact of
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improvements in the quality of goods and
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services included in the basket
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you can check out others in the
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explainer on inflation and its
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measurement
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on the rba website let's start by what
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the cpi
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does not measure the cpi is an index so
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it tracks how
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prices of items in the basket change
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over time
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but does not provide an indication of
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the level of those prices
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for example it can tell you that fruit
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prices have increased three percent last
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year
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but it does not tell you what that price
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is
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second the cpi measures price changes in
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the metropolitan areas
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of australia's eight capital cities this
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is where two-thirds of australian
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households live
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but it does not measure price changes in
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regional rural or remote areas
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which may evolve differently to prices
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in metro areas
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cpi is not an ideal measure of changes
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in the cost of living
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cost of living inflation is the change
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in spending
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by households required to maintain a
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given standard of living
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so it is based on the choice of that
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specific standard of living
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and not on the spending of the average
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household another challenge comes from
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the fact the cpi basket is fixed
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if you recall from earlier we looked at
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the shares or weights
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of the different items in the cpi basket
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these weights are adjusted
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annually but households can change their
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spending behavior at any time
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including in response to changes in the
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price of goods and services
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this can lead to what we call
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substitution bias
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for example imagine if the price of beef
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increases but the price of land stays
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the same
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households will buy less beef and use
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some of this income
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towards buying more lamb a close
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substitute for beef
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even though households have changed the
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amount of income they spend on beef and
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lamb
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the weights in the basket remain the
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same households now spend less income on
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beef and more income on lamb
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this means that too much weight is given
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to beef prices
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which have increased and not enough to
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land prices
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which have not the result is that cpi
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inflation will be a little higher
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because the higher price will be given
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more weight than it deserves
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this is what we call a bias
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if we look at recent times during the
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covet 19 pandemic
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there have been large changes in
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consumption expenditure shares
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for example travel restrictions and
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social distancing
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resulted in household spending more on
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home entertainment
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and groceries instead of going on
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international holidays
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or eating out but the weights for these
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items in the basket
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did not change among other things
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this makes it more difficult to use cpi
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to understand the inflationary pressures
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in the economy
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lastly cpi is intended to measure pure
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price changes
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and not changes in the prices paid for
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items
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what we mean by this is that cpi should
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ignore changes in actual prices paid
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that are caused by a change in the
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quality of an item
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for example if the size of a bag of
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pasta doubles
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and the price doubles as well there has
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actually been no change
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in the pure price of pasta once you
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adjust
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for the change in the size of the bag
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however a more complicated challenge
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appears when for example you add a
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better camera
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to a mobile phone in this case the price
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paid will go
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up but part of the increase will be
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connected to the change in the quality
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of the camera
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so the abs will want to remove the
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increase in price that is due to the
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improved quality of the mobile phone
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so it can do a like for like comparison
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quality adjustments for services are
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particularly difficult to measure
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for example how do you measure the value
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of an improved haircut
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because these adjustments are only
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estimates they can result in
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under or overestimation of the pure
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price changes
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and so under or overestimation of cpi
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inflation the size of these adjustments
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can potentially be meaningful for some
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items
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for example high-tech items which are
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continuously improving
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we'll leave it here for our overview of
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the cbi basket
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calculating inflation and some of its
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challenges
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some useful links are provided in the
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description
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see you next time
