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APPENDIX 3 ANALYSIS OF THE CONCEPTUAL APPROACHES TO CONSTRUCTING A CPI
5. Expenditure on a financial product serves to rearrange the individual’s financial holdings by exchanging one type of financial product for another (i.e. a change in the household's balance sheet). The creation or extinction of financial assets/liabilities by lending, borrowing and repayments, are financial transactions that are different from expenditures on goods and services and take place independently of them. For example, households may borrow in order to finance final expenditure (e.g. on housing, holidays or medical services). A financial transaction merely rearranges the individual’s asset portfolio by exchanging one type of asset for another, as such no consumption occurs. Expenditure on financial products is excluded from the CPI (ILO, 2004).
6. While it is agreed that no consumption occurs, elements of the transactions may attract an explicit charge or bundle an implicit service charge in addition to the provision of an asset, such as a loan. In principle, the bundling of a charge with a another monetary payment does not preclude the charge from being MFE (ILO, 2004). Financial services therefore represent consumer expenditure on the service related to financial products rather than expenditure on the financial product itself. As a service charge constitutes the purchase of a service by the household, it is included in a CPI.
7. Investment related financial services (e.g. stock broking fees, real estate agent fees) and directly and indirectly measured intermediation services, are considered MFE. See Chapter 4 and Appendix 6 for a more detailed examination of indirectly measured financial services.
8. Where the CPI is intended to be a measure of household consumer inflation, there is international support for the use of the acquisitions approach for general CPI construction and for OOH. The Harmonized Index of Consumer Prices, which is primarily designed for comparison of price development between European countries, considered the relative merits of the different approaches to OOH. Conceptually the acquisitions approach is preferred by Eurostat to construct the OOH component (Eurostat, 2010), even though OOH is currently excluded from the Harmonized Index of Consumer Prices.
9. CPIs are generally referred to as cost of living indexes (COLIs), however the term covers two specific ways in which a CPI is constructed; a fixed basket COLI approximation, constructed under the cost-of-use approach, or a true fixed utility COLI.
10. When the CPI is intended to approximate a fixed basket COLI, some imputed expenditures are included within the scope of the CPI on the grounds that the goods and services acquired in non-monetary transactions affect households’ living standards. To account for household welfare the flow of services to a household from durable items is measured, including the services of residential structures that are owned wholly or in part by the occupants, that households consume (ILO, 2004).
11. Because of the conceptual and practical difficulties involved in measuring the flow of services from durable items, statistical standards tend to promote the acquisitions approach for the measurement of the majority of consumer durables in the National Accounts and CPI with the exception of OOH (which is measured as the flow of services from the durable good). Generally, CPIs described as cost-of-use are, in effect, hybrids between the acquisitions and cost-of-use approaches (see Appendix 4).
12. The profile of a CPI constructed on the cost-of-use approach, as supported by the ILO, is as follows:
13. Fixed basket CPIs differ in important ways from a true COLI, which is described in the CPI Manual as “...an index that measures the change in the minimum cost of maintaining a given standard of living" (ILO, 2004). A COLI follows a fixed utility approach and is not based on a fixed basket of goods.
14. Fundamental to the cost of living approach is the notion that the items which make up the CPI basket are allowed to change over time, as is the composition of outlets where these goods are purchased. As a result, in the cost of living approach the basket of goods is not fixed over time.
15. A COLI takes into account not only the consumer’s preferences but all the non-price factors that affect the consumer’s welfare and standard of living. However, it is not possible to directly observe the cost of achieving a standard of living, so a true COLI can only be approximated.
16. Theoretically, superlative indexes can be used to approximate a COLI. However in order to construct a superlative index, price and quantity (expenditure) data are required for all periods under consideration. Given that current period expenditure data are not available on a sufficiently timely basis, a superlative formula is not considered a practical measure for the routine production of the CPI (ILO, 2004).
THE OUTLAYS APPROACH
17. The outlays approach is mostly used when the primary purpose of the CPI is for the adjustment of incomes. An index designed to measure changes in the purchasing power of household incomes would need to be concerned with changes in the costs of all expenditures made from household income.
18. Proponents of this CPI aggregate see purchasing power of incomes determined by measuring actual money flows (i.e. out-of-pocket expenses, including interest payments) out of the household.
19. When the CPI is intended to approximate household out-of-pocket living expenses, mortgage interest and consumer credit charges in addition to MFE are captured. The capture of these interest payments are the main points of difference compared to other conceptual approaches. The inclusion of mortgage interest means that expenditure on a new house purchase (acquisitions approach) or flow of services from the dwelling (cost-of-use approach) are not included.
20. As the outlays approach differs from other aggregates by including interest, these aspects make it unsuitable for inflation targeting due to the feedback loop from changes in the cash rate target. While not specified as a reference aggregate, it is supported in the CPI Manual (ILO, 2004). Australia has several indexes based on this approach such as the ALCIs, and, prior to the 13th series, the CPI itself.
21. The profile of a CPI constructed on the outlays approach is as follows:
22. With the change of principal purpose and design of the CPI in 1998, the ABS developed a series of analytical measures specifically designed to measure changes in living costs for a range of population subgroups. Based on the outlays approach, these ALCIs have been designed specifically to measure the impact of changes in prices on the out-of-pocket living costs experienced by selected groups of Australian households. The most recent addition to this family of indexes was the Pensioner and Beneficiary Living Cost index (PBLCI), which was developed in 2009.
23. As with the CPI, the ALCIs are based on a fixed basket and are unable to immediately reflect changing consumer preferences and the substitutions that consumers make in response to changes in relative prices.
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