Every country is concerned with expenses that households incurs when buying goods and services which help them to maintain their living standards. The price of goods and services usually raise over time which results to upward pressure in the living cost. According to David, Dilhan and Thomas (2014), Consumer price index (CPI) measures the inflation price which helps to determine the change in the cost of living. It helps to measure the change in price level of a market basket for goods and services purchased by households.
According to Mankiw (2002), the monetary policy in Australia has been targeting CPI inflation of average of 2 to 3 per cent over the past six years. He further stated that there has been an increase in cost of living for Australian households over the past few years.
Consumer price index
Consumer price index has played an important role in economic indicator over many years and it has directly and indirectly impacted Australian. It helps to determine the price inflation in the household sector and it is also used by Reserve Bank of Australia as a key measure of inflation in evaluation of monetary policy. Anil (2019) stated that the purchasing power of Australian dollar is dragged down by inflation.
Change in CPI results to regular modification by businesses such as insurance companies, rental industry, and child support payments.
Australia CPI basket
According to Moody’s analytics (2019), Australia CPI basket is comprised of wide range of goods and services which are arranged in eleven groups.
● Alcohol and tobacco
● Clothing and footwear
● Household contents and services
● Financial and insurance services.
RBA (2018) wrote that the consumer price index does not show the level of the price but it measures the rate of price change in the economy. CPI has some disadvantages as described below
● Coverage – CPI is used to measure change in item price in the metropolitan areas of Australia’s eight cities where almost two thirds of households in Australia lives. Therefore, CPI do not measure price changes in regional, rural or remote areas. It does not also consider the differences in spending patterns between individual households since some spends a lot more on a certain items than others.
● Quality changes – CPI only calculate pure price changes, it ignores the price changes that result from the quality of items fluctuations. The quality of items varies and a new products. The quality of items in the basket can vary and sometimes a new product is introduced. If item prices change due to improved quality, ABS does not calculate change in quality but they estimate the price changes by comparing the current price and the previous one, this can result to under or overestimation of the pure price change. When there is an adjustment in services, it is usually hard to measure the improvement since the changes often occurs slowly.
● Substitution bias- Substitution bias has an impact on CPI since it does not modify the changes in household spending behavior frequently. Some years back, ABS used to update CPI basket after 5 to 6 years but from 2017, they stated updating CPI weights every year which helps to reduce the substitution bias in the CPI.
● New products – New products are not taken into account by CPI as soon as they enter into the market. It is usually included when it attains a higher share in the market and when it is available to almost all Australian households.
● Cost of living – Often, CPI is used in measurement of changes in the cost of living but it is not the perfect indicator. Since CPI measures change in price, the cost of living inflation is the change in spending by households which requires to be maintained in order to give standard of living. The ABS usually publishes other indexes that intend to provide a better indicator of the cost of living.
Monetary policy shows the relationship between interests rates in an economy which focus on money borrowing and the total supply of money. Various types of tools are used to control them and they have an effect on economic growth, inflation, exchange rate and unemployment.
The Reserve Bank is responsible for Australia’s monetary policy. Monetary policy is used to set up the interest rate on overnight loans in the money market which influences other interest rates in the economy, affecting the behavior of borrowers and lenders, economic activity and ultimately the rate of inflation.
In Australia, monetary policy is used to influence aggregate demand, employment and inflation in the economy through interest rates. The cash rate influences other interest rates in the economy which, in turn, influence economic activity, employment and inflation. Blanchard (2000) defined inflation as a continuous increase in general price level of goods and services in an economy over a period of time Blanchard (2000). He further stated that when the price increases, the consumer price index reduces. CPI can also be used as an indicator for the real values for salaries and wages in regulation of prices and for deflating monetary magnitudes to show changes in real values.
According to Bordo (2008), monetary policy deals with interest rates and availability of credit. Short term interest rates and bank reserves are the instruments of monetary policy through monetary base Bordo (2008).
There are two forms of monetary policy namely; decisions about coinage and decisions to print paper money to create credit Iyiola, R. & Adetunji, A. (2014).
Monetary policy is used by Reserve Bank Board to determine the interest rates. The role of Australia monetary policy is to stabilize the Australian currency, maintain full employment in Australia, and maintain economic prosperity and welfare of the Australians.
Consumer PPrice Index