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CHAPTER 2 PURPOSES AND USES OF CONSUMER PRICE INDEXES
Purchasing power of money incomes
2.4 A CPI designed to measure the purchasing power of money incomes is concerned with answering questions such as how much income is required today to purchase the same basket of goods and services that was purchased in the base period. The appropriate domain of the basket in this case is all those outlays on consumer goods and services actually made by households in the base period.
2.5 For this purpose the correct measure of income to use is net income (i.e. after income tax), not gross income. Application of the index to gross income is only valid if income tax is proportional to income, and the treatment of property income is identical to that of wage and salary income. A progressive income tax regime, such as that applying in Australia, emphasises the need to use net income. In addition, as the significance of different sources of income and expenditure varies considerably between household types, changes in purchasing power are best assessed by type of household rather than in total.
Assessing changes in living standards
2.6 In assessing changes in living standards, the CPI is used in conjunction with data on expenditures by households to measure changes in their volume of consumption of all goods and services.
2.7 For this purpose, the first thing to do is to define standard of living. A narrow definition of standard of living is the volume of goods and services consumed by households in the base period. For many consumer items, the acquisition of, the payment for, and the consumption of, an item all occur at about the same time. However, for some items the volume of the item consumed in a period may have little relationship to the payments made in the period. A good example of this is a consumer durable such as a private motor vehicle where the vehicle may have been purchased several years earlier. For other items, the price is substantially below the economic cost of providing the good or service, so that the expenditure is not a true reflection of the quantity of the item consumed. Typical examples of this are services provided by the public sector such as education and medical care. Estimates must be made of the economic value of these items actually consumed in the base period.
2.8 Estimates of the market value of the consumption of consumer durables can be made by reference to the market prices of similar items (thus private rents can be used as an indicator of the value of owner-occupied housing, and leasing charges for households' fleet of motor vehicles). For insurance services, estimates of the service component (essentially operating costs plus profit) are derived from the published accounts of insurance companies. For publicly supplied goods and services, the ABS compares their prices with those of private suppliers of similar services or makes estimates based on the cost of providing the service (e.g. teachers’ salaries plus building and running costs for educational services).
2.9 Of course, a broader definition of living standards is possible. It might include environmental conditions such as the quality of air and water, or the area of national parks. Although these are important in their own right, the measurement of these factors, the value placed on them by households, and the means of including them in an index of living standards, are as yet insoluble problems (see Pollak (1998)). So for practical reasons, the narrow definition is used.
2.10 Against this background, the domain for an index designed to assess changes in living standards would include:
2.11 This measure accords with the concept of Household Final Consumption Expenditure (HFCE) in the Australian National Accounts.
Measuring household inflation
2.12 Another possible purpose of the CPI is to measure price inflation facing households as consumers. This measure is primarily for use in macroeconomic management, and also has some possible uses in contracts where an index of prices for household consumption items is appropriate. Of course, as the CPI measures only households' price experience, it is not a measure of economy-wide inflation.
2.13 As there is no generally agreed definition of inflation, the issue of how it should be measured is complicated. Nevertheless, it seems clear that an index of household inflation should attempt to measure the contemporary rate of change in prices of consumer goods and services.
2.14 An important aspect of a measure of inflation is that it should only include market-determined prices. Thus, an inflation measure would not include imputed rent of owner-occupied dwellings (which, however, would be included in a cost-of-use approach as discussed below). A measure of house prices would be more appropriate, if housing is not considered an investment. Financial assets would not be considered a good or service, thus prices of shares and the like would be out of scope. However, such a measure would need to capture changes in the service charges of intermediaries involved in financial and asset-transaction services, such as banks, insurance companies, and real estate agents.
2.15 It could be argued that an inflation measure should also exclude goods and services provided to households at subsidised prices. The reason is that the inflation rate has implications for government policy, and as such it should be determined by market forces unhindered by the actions of governments themselves. The argument goes that subsidies are distortions of pure market forces, and subsidised prices do not reflect the true market price (or economic value) of the goods and services. However, the treatment of taxes, and subsidies which are regarded as negative taxes, should be symmetrical. Excluding subsidised goods would lead to some significant goods and services (e.g. education) being omitted that would otherwise be considered essential for complete coverage in a CPI. Consequently, the most common practice is to include subsidised goods and services.
2.16 The domain for a measure of household inflation would thus include:
2.17 As it presently stands, the Australian CPI is specifically designed to provide a general measure of price inflation for households residing in the capital cities.
CONCEPTUAL APPROACHES TO CONSTRUCTING A CONSUMER PRICE INDEX
2.18 Once the purpose of a CPI is decided, a method of construction can be worked out to satisfy that purpose. Consistent with the three purposes outlined above, there are three possible conceptual approaches for constructing a CPI. These approaches are consistent with the ILO Resolution which says that "...a reference population acquires, uses or pays for consumer goods and services".
These are the three methods.
(i) The Acquisitions method: in the base period, all goods and services acquired (i.e. actually received) by the reference population are included in the CPI regardless of the period in which payment or use occurs.
(ii) The Cost-of-Use method: in the base period, all goods and services used (i.e. consumed) by the reference population are included in the CPI regardless of when they are paid for or acquired. In particular, the cost of using the good or service is measured by its true economic cost.
(iii) The Outlays method: in the base period, all goods or services for which payments were made are included in the CPI without regard to the source of the funds.
2.19 The acquisitions and outlays approaches are similar. The acquisitions approach leads to a CPI basket that can be viewed as a subset of the basket resulting from an outlays approach. Both conceptual approaches include goods and services acquired during the base period, but the outlays approach also effectively includes any inescapable costs associated with the acquisition of a good or service, such as interest charges. The cost-of-use approach can result in a basket that differs from both the acquisitions and outlays approaches.
2.20 The choice of conceptual approach for construction of the index depends on the purpose. The approach that is most appropriate for each of the three possible CPI purposes is outlined below.
(i) Purchasing power of money incomes. In order to determine changes in the purchasing power of money, an outlays approach is most appropriate. The outlays approach provides a proxy for household income through measurement of consumer outlays.
(ii) Assessing changes in living standards. The cost-of-use approach provides the best indication of changes in living standards as it relates to goods and services actually consumed in the base period.
(iii) Measuring household inflation. The acquisitions method is the most appropriate for this purpose. A measure of household inflation should relate to the contemporary rate of change in the prices of goods and services. The acquisitions approach captures this by measuring changes in the prices of goods and services actually acquired in the base period.
COMPARISON OF THE CONCEPTUAL APPROACHES
2.21 In practice, for most goods and services purchased by the reference population, outlay, acquisition, and use all occur within a short period, and the price paid by the reference population is a true economic value, effectively making the distinction between the approaches academic. However, in some cases there can be significant lags between outlay, acquisition, and use; or the price paid may differ significantly from what is considered the true value.
2.22 There are three areas of household expenditure in which these conceptual approaches provide significantly different results. These are:
(i) the purchase of housing;
(ii) the purchase of durable goods; and
(iii) financial services, including the use of credit.
2.23 To illustrate the differences among the three approaches, the way in which these three special cases are treated under each approach is outlined below.
Expenditure on housing
2.24 Under the acquisitions approach, the required measure is the change in prices for both the net purchase of housing, and the increase in the volume of housing because of renovations and extensions, plus other costs incurred in ensuring the continued supply of services provided by owner-occupied dwellings (e.g. maintenance costs and council rates). Changes in rents are measured for that part of the reference population that resides in rented dwellings. Costs such as maintenance of rental dwellings are paid by investors who are out of scope of a CPI.
2.25 Under the outlays approach, the required measure includes changes in the amount of interest paid on mortgages, and the costs incurred in ensuring the continued supply of services provided by the dwellings (e.g. maintenance costs and council rates). Also included are changes in rents which are measured for that part of the reference population that resides in rented dwellings.
2.26 Under the cost-of-use approach, the required measure is the change in the economic value of the services provided by dwellings. The price of these services is usually measured as the rental value of the dwellings. For owner-occupied dwellings, the rental values are imputed. Costs such as maintenance costs are not included as they are part of the cost of maintaining an investment, and so are outside the scope of a CPI.
2.27 For durable goods, the three approaches result in the following treatments.
(i) Acquisitions - the basket includes those durable goods acquired in the base period, and their price measure is the transaction (purchase) price.
(ii) Outlays - the basket includes those durable goods paid for in the base period, and their price measure is the transaction price.
(iii) Cost-of-use - the basket includes the services of durable goods consumed in the base period, regardless of the period in which they were purchased, and the price measure is the market value of the services provided by those goods (measured in business accounts as depreciation plus the return on investment).
Financial services and the use of credit
2.28 Under the acquisitions approach, interest paid is not a charge that is within scope of the CPI basket of goods and services. The service for which prices are required is that of providing banking services (including the provision of loans).
2.29 Under the outlays approach, the product being priced is the cost of servicing loans taken out to purchase products that are part of the CPI basket. Thus the change in the level of interest paid on this debt is the required price measure.
2.30 The cost-of-use approach requires that the cost of the financial services used is measured in a similar manner to the acquisitions approach.
2.31 Although these alternative approaches to the construction of a CPI are characterised by conceptual differences, they are more likely to result in short-term rather than long-term differences in outcomes. This is particularly so with the acquisitions and outlays approaches. In practice, each approach covers a broad range of consumer goods and services which tend to have similar long-term price behaviour in the absence of external shocks or institutional change. In addition, there are many items common to all three approaches.
THE AUSTRALIAN CONSUMER PRICE INDEX
1997 Review and the adoption of an acquisitions basis for the CPI
2.32 In 1997 a major review of the CPI was conducted, involving consultation with a wide range of organisations and individuals representing government, social, business and community interests. This review concluded that the ABS should change from an outlays index for wage and salary earner households and adopt an acquisitions approach as a general measure of household inflation for all private households. Since the introduction of the 13th series CPI in the September quarter 1998, the CPI has been compiled on an acquisitions basis. Another major review of the CPI was conducted in 2010 which concluded that, with the introduction of the 16th series CPI, the acquisitions approach continue to be used in the compilation of the CPI. For more detail on the 1997 and 2010 Reviews, see:
Uses of the CPI
2.33 A major use of the CPI is to assist government economists in conducting general economic policy, especially monetary policy. Since 1993, Australian monetary policy has been conducted with the aim of meeting a medium-term inflationary target. Since the introduction of the 13th series CPI in the September quarter 1998, that target has been the inflation rate as measured by the CPI. Additional analytical series including the international trade exposure and underlying trend estimates are also used to assist in understanding inflationary trends.
2.34 The CPI, or one of its components, is also widely used in indexation arrangements in both the private and public sectors. These include indexing pension and superannuation payments, taxes and charges, some governmental bonds, and business contracts.
2.35 In Australia, the use of the CPI in wage determination has diminished with the trend towards decentralised, enterprise-based wage and salary setting arrangements with outcomes focused on the commercial circumstances of each business.
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