Inflation

Question 1

what is inflation?

Answer 1

General increase in price and fall in purchasing value of money
It combines all of the information on individual prices and produces an aggregate measure. Overall, 2% inflation average since mid- 1990s, in range 0-5%

Price - a nominal price a price denominated in money
relative price - of haircut to beer 7:1

Question 2

How do prices behave?

Answer 2

• in any month, about 80% prices remain unchanged
• of those over half go up, under half go down
• since 1988, CPI index risen from 47 to 131 in July 2023, rise of 180% in 35 years
• CPIH (official measure) risen 47 to 129
  Food pretty much in line with CPIH

Question 3

Individual price trajectories?

Answer 3

a series of price quotes from the same seller for the same good

Question 4

Measures of inflation - 1. RPI

Answer 4

• RPI first measure of inflation
  Started measuring RPI in June 1947. Prior to that, there were some measures: primarily at the Department of Applied Economics in Cambridge
  Used the (first ever) 1937-38 household expenditure survey for expenditure weights.There were various changes, but mostly minor. Main debate was how to calculate the cost of housing and the role of mortgage payments.

Question 5

Conclusions 1

Answer 5

1. Most Prices go up and down all the time. Lots of “micro volatility”: prices respond to local market features (supply and demand, changes in competition etc.)
2. Some categories of prices have been coming down in recent decades (footwear and clothing, Audio visual).
3. Inflation: captures the general in crease in prices. It combines all of the information on individual prices and produces an aggregate measure. Overall, 2% inflation average since mid- 1990s, in range 0-5%.

Question 6

History of inflation?

Answer 6

 Prior to 1900, inflation was transitory, volatile and frequently negative.
 Little cumulative inflation. In 1750 the price index level was 5.1. In 1914 it had risen to 9.8. There were times when it was higher than 1914:e.g. the Napoleonic wars (in 1813 it “peaked” at 16.3)
 1914-1920 inflation took level up to 25.3. Fell back a bit in 1920-35, but since 1935 ALWAYS increasing.
 1945: 26.2 (about same as in 1920)
 1955: 43.1
 1965: 58.4
 1975: 134.8
 1985: 373.3
 1995: 588.2
 2003: 715.2

The period since 1935 has been one of ever present inflation: very few periods of negative inflation (monthly).
Prior to 1900 almost no inflation (people would not have noticed it: just short run changes in particular prices

Question 7

RPIX?

Answer 7

Originally known as the All items RPI excluding Mortgage payments, it eventually became known as RPIX.
In 1992 it was used to define the target for the Bank of England post ERM, with a “range” of 1-4%.
RPI includes mortgage payments, so if and when a rise in the policy rate leads to an increase in mortgage rates, this directly causes inflation to rise. This was viewed by some as perverse, so better to think in terms of RPIX
* RPIX excludes mortgage payments as a rise in IR would raise mortgage payments, means BOE wouldn’t affect directly

Question 8

RPI and RPIX?

Answer 8

1. When mortgage rates are constant, there is little difference between RPI and RPIX:for example the period in the UK since interest rates hit the zero lower bound in2009.
2. When mortgage rates vary with inflation, there is also little difference: for example, prior to 1982.
3. They differ when mortgage costs vary differently to other parts of RPI. This happened over the period 1985-2009. RPIX is more volatile than RPI inflation. If real interest rates are pro-cyclical, this can happen.
4. The contrast of RPI and RPIX illustrates the point that the coverage of the price index(what it includes and what it leaves out) will influence its volatility and possibly its level

Question 9

Consumer Price Index?

Answer 9

The European Union decided on using the Harmonised Index of Consumer Prices (HICP)for using across the EU. The HICP is specified in a series of legally binding European regulations starting with Regulation number 2494/95 of 23 October 1995. Updated by agreement across Eurostat and the NSIs (including the ONS).

In 2003, the UK National Statistician decided that the UK version of HICP would be known as the CPI (the American name), and at the same time Chancellor Gordon Brown moved the Bank of England inflation target from RPIX to CPI.

Question 10

CPI differences?

Answer 10

• expenditure weights –
• CPI all expenditure of all HH and visitors (tourists), RPI exc pensioners and richest 4%
• coverage –
• became more comprehensive and detailed, extended to health, education and financial services, used COICOP classification
• still largely exc parts of costs of owner occupied housing
• In practice, RPI could be updated to mimic CPI other than a fundamental difference -Formula effect –
• price relatives are averaged according to arithmetic average in RPI (Carli)
• In CPI a geometric index is used (Jevons)
• the formula effect means that when prices in the index change differently the RPI tends to be higher than the CPI, as much as 1%

Question 11

Volatility?

Answer 11

RPI more volatile than RPIX and CPI
Mean inflation 1989-2017:
RPI and RPIX were both 3.3%, CPI 2.6%.

Standard Dev:
RPI 2.02
RPIX 1.63
CPI 1.78

Question 12

CPIH?

Answer 12

Official price index for the ONS, CPI is BOE target
CPI excludes large part of housing costs - owner occupied housing (mortgages) - accounts for large share of aggregate HH expenditure (~10%)

• 10% of GDP constructed from computed rent
• 2012, owner occupier cost expenditure weight in CPIH was 11.6%
• CPI more volatile as rents change more gradually (owner occupied)
• 2006-2017, CPIH less than CPI

Mean:
CPIH 2.2% CPI 2.6%
St Dev:
CPIH 1.0 CPI 1.26

If BOE switches to CPIH - target should be lower as is less variable - however could just be for this historical period

Question 13

Rental Equivalence?

Answer 13

The underlying concept for a rental equivalence price index is that a dwelling is a capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period. Such services encompass shelter and security of tenure. The value of the flow of services that owner occupiers receive is assumed to be the same as the rent that the dwelling might attract in the rental market. Rental equivalence imputes owner occupiers’ housing costs from the rents paid for equivalent rented properties. Put more simply, it is ‘measuring the price owner occupiers would need to pay to rent their own home’.

Question 14

The difference between CPIH, RPI and CPI – Owner occupied housing?

Answer 14

The roots of this debate go back a long way. How do you measure the cost of housing to people who own their own housing (OOH). It is an issue, because actual payments made may not reflect the “economic” or full cost

Question 15

3 methods for measuring cost of housing for OOH?

Answer 15

• 1. Rental Equivalence – imputed rent as no actual rent is paid
• 2. Payments – aiming to measure payments related to ownership of OOH – all payments when consuming housing is inc such as mortgage interest, transaction costs and running costs (not all have mortgage payments) – so is actual cost paid
• 3. Net Acquisitions – costs of acquiring house w household to household transactions netted off – treats a home as purchase of a good that is part asset (land) and part consumable (house), excluding land component – also inc costs w buying and maintaining, self-build, renovations, dwelling insurance etc. (never used as would need a lot of data)
• mortgage payments – only interest element that counts

Question 16

How do you measure the cost of a housing in a particular month (as required by CPI)?

Answer 16

In practice, in UK we have used both Rental equivalence and Payments (RPI only included rents in early years – mortgages rare in 1950s).Until 1960, UK house owners were taxed on the imputed rental income (still are in some countries), so there was good data on this from HMRC.RPI used a “payments based” approach. CPI and RPIX excluded housing and CPIH current measure:

Question 17

Components of the three approaches of measuring owner occupiers’ housing?

Answer 17

Rental Equivalence (CPIH) - Imputed rents

Payments (RPI) - mortgage interest payments, council tax, Northern Ireland rates, dwelling insurance, ground rent, stamp duty, estate agent fees, home-buyers survey, major repairs and maintenance, house conveyancing

Net acquisitions - acquisitions of new dwellings, self-builds and renovations, existing dwellings new to the OOH sector, services related to acquisition, major repairs/maintenance, insurance connected with dwelling, other services related to ownership

Question 18

For an economist a.) should adjust for inflation?

Answer 18

you should adjust for inflation. The real interest rate is equal to the nominal interest rate less inflation (the fisher equation). When inflation is 10% and the nominal interest rate is15%, the real interest rate is 5%. 10% of the interest payments are going to paying off your debt (which shrinks with inflation). Only 5% represents a real cost.

-For example, a £100k mortgage. After one year the “real” value of the debt has gone down by 10% and is only £90k in terms of the initial prices. 10% of the interest payment goes to offset this. At the end of the year, the lender has a total of £115assets (the £100k loan plus interest payments of £15k). The £100 loan adjusted for inflation is now £110k. That leaves over a £5k profit, 5% of original loan.

Question 19

An economist should adjust for b.) capital gains?

Answer 19

• should also be including capital gains – user cost of capital – house increasing in value, e.g., take on a loan for housing and house increases in val, effectively paying off your debt in longer run – rental equivalence doesn’t really capture this as demands using a ‘lifetime’ perspective

Question 20

GDP (rental equivalence)?

Answer 20

OOH services included in GDP.
Thus the “imputed rent” corresponds to the “output” of housing services provided by OOH (and is an imputed expenditure and income which nets itself out).
This was a decisive factor: OOH has been in GDP for a long time. Rental equivalence fits well with it

Question 21

Chaining - a first look?

Answer 21

• a price index takes ref year or month set to 100 as a base to express all prices in terms of this base
• we divide each p by ref price and x100
• maintains the ratio of prices in any 2 months

Question 22

Chaining - don’t know prices just the index?

Answer 22

Index Jan to July
And, suppose that we have a sequence of the index for July to December, with a reference month of October.
How
How do we combine these two series into 1? This is called “chain Linking” or just “chaining”.To do this, you need at least one month of overlap. We have this, the month of July.
Step 1: Choose which month of the whole series you wish to set at 100. Let’s assume that we want to use October from the second series. We will need to adjust the first series so that it“fits” with the second series at the overlap month (July).
Step 2: Take the July from the first series and multiply it by a constant so that it equals the value. Lets take the first series where July =100. In the second series, July is 96.3: so we need to multiply the first series July = 100 by the constant (96.3/100)=0.963.

Important point: an index series preserves relative values (for example October relative toMarch, December relative to August). It tells us nothing about the absolute value: to get this, you need at least one “raw price” (or for a basket of goods one average price).This is why you need to multiply all of the series by a constant. It preserves the relative values across time.If you added a constant it would not do this! Try it: take any sequence of 3 numbers and add a constant to each. The relative values change. Multiply by a constant and they remain the same.