Oran Hall | Understanding inflation

Inflation is the sustained increase in the general level of the prices of goods and services used by consumers or private households.

The rate of inflation is the percentage change in the average price level of a fixed set of goods and services – otherwise referred to as the ‘inflation basket’ – in an economy over a given period.

The consumer price index, or CPI, is a major index used to measure inflation by applying the following formula: CPI in the current period less the CPI in the previous period divided by the CPI in previous period, multiplied by 100.

It measures the changes in the average price of a representative basket of goods and services the typical household uses –for example, food, clothing, transportation, housing, and education. A household may be one person or a group of people living together who pool their resources for food and other necessities.

The goods and services included in the CPI must be important to the household based on how much it spends on them relative to its overall expenditure. The quantity of items in the basket is fixed, that is, kept constant, but the cost of the fixed basket changes as the prices of the items change from one period to another.

The prices used must be associated with specific quantities, such as one litre of ‘Hanover Farms milk’, which is what is determined each time a survey is done by the Statistical Institute of Jamaica (STATIN).

Statin reports inflation on a monthly basis. For the month of November, prices were relatively unchanged, so the inflation rate was zero. Point-to-point or annual inflation was estimated at 7.8 per cent as at November.

Although rising prices affect the standard of living by reducing spending power, the CPI does not measure changes in the standard of living because living standards differ from individual to individual.

Changes in living expenses, or the cost of living, may be due to changes in lifestyle, or living standards, such as a person moving from one community to another where rent is higher. It is, nevertheless, useful in determining the amount of money that would be needed in the present to have the same purchasing power as another amount at some other point in the past.

The amount of inflation is measured by the change in the cost of the basket of goods and services. All the items do not have the same importance, or ‘weight’, in the basket as this a function of the amount spent on each item compared to the total household spending.

As such, items recording the same level of price movement will not necessarily have the same impact on inflation because of the difference in their weight in the basket. Additionally, because the basket of individuals differs, the impact of inflation on individual households is different.

Although there is an inflation rate for the whole country, it is clear from reports published by the Statistical Institute of Jamaica that the level of price increases experienced in one region of the country is different from that of another region. For example, the level of inflation experienced in the Kingston Metropolitan Area tends to differ from that experienced in other towns.

It sometimes becomes necessary to update the CPI basket to ensure its continued relevance to the spending habits of the households to which it relates. The tool used in Jamaica to collect the information on how households spend is the Household Expenditure Survey, conducted every 10 years.

The new data are used to update the basket. Goods and services that become important are added to the basket and the weight of those that become more important is increased. Goods or services that become less important are removed from the ‘basket’, or their weight is reduced as the case might be.

As goods and services require more money to purchase, the implicit value of that money falls. The growth in the supply of money relative to the supply of goods and services available for purchase tends to lead to demand-pull inflation, described as ‘too much money chasing too few goods’. Cost-push inflation is an increase in prices due to increases in the prices of the factors of production, for example, labour and raw materials.

Sometimes people wonder why prices rise although the rate of inflation is falling. This decline in the rate of inflation is called disinflation – the decline in the rate at which prices increase. This is not the same as deflation – a sustained fall in prices evidenced by the annual change in the CPI being negative, the opposite of inflation.

From the point of view of the individual, low inflation is important as it makes it easier to plan, to maintain purchasing power and to manage the cost of living. High inflation causes uncertainty and makes it imperative to pursue an investment policy that puts a high priority on hedging against inflation, which generally carries a higher level of risk.

- Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com