Factors Contributing to Recent Canadian Inflation

Factors Contributing to Recent Canadian Inflation DOUGLAS C.A. CURTIS In a recent note in The Economic Journal, R.G.D. Allenl illustrated a method used by The Bank of England to estimate the separate effects of four main factors that contribute to the rise in market prices. In this paper, a similar methodology is employed to estimate the 'contributions' of wages and salaries, profits, indirect taxes, and import prices to recent Canadian inflation. The resulting estimates provide some insight into the causes of both the sharp increase in the Canadian rate of inflation from 1972 to 1974 and the persistence of inflation in 1975 and 1976 despite rising levels of unemployment. The methodology suggested describes inflation in terms of the broadest and most comprehensive index of market prices, namely, the implicit Gross National Expenditure price index. This price index reflects changes in the market prices of all final goods and services produced andIor purchased in Canada in a given time period. By a simple transposition within the national accounts framework it is possible to identify four main components of this index, namely: employment income, profits, import prices and indirect taxes net of subsidies.2 The first two of these components, when assessed relative to output, may be regarded as domestic costs of production while import prices and net indirect taxes per unit of output are items that enter into the national accounting framework in adjusting national income at factor cost to GNP at market prices. Movements in the aggregate price index thus correspond to movements in one or more of these major components. It is important to stress that the statistical method is descriptive. A change in the GNE price index must equal the weighted sum of change in the components of the index to satisfy the price level identity. The relationship is similar to the relationship between changes in GNE and changes in the components of aggregate demand. Explanations of the cause of observed movements Journal ofCanadian Studies Vol. 13, No. I (Printemps 1978 Spring) in the aggregate thus depend on hypotheses regarding changes in the aggregate price index and its components. This task is deferred to the later part of this paper. Estimating the changes in the individual components relating to quarterly changes in the GNE price index involves two steps. The first is to construct quarterly indexes of labour cost per unit of output, profit per unit of output, net indirect tax rates and import prices.3 The second is to estimate the weights to be attached to each of the components in computing its impact on the GNE price index. Recent issues of the Bank of Canada Review provide the quarterly data used to construct the indexes presented in Table I. Using the index numbers of Table I the changes in each of the main components of the index relating to the change in the GNE price index can be calculated. The procedure involves weighting the observed change in each index, from its 1970 value of 100. The weights used represent the share of each of the components in the 1970 estimate of final national output or expenditure.4 There are a number of potential 'index number problems' in this procedure but the intention is to arrive at a reasonable approximation of component changes. An illustration of the above procedure will perhaps clarify the interpretation of the estimates presented in Table II. For the first quarter of 1971 as shown in Table II: o/o Change 1970 Component from 1970 Weight Product Employment income per unit of output + 1.5 .487 0.7 Profit per unit of output - 2.0 .137 -0.3 Net Indirect Tax Rates + 2.2 .118 0.3 Import Prices + 0.1 .211 Estimated change in index 0.7 Observed change in index 1.3 Error-0.6 The sum of the estimated components is not exactly equal to the observed change in the GNE price index for several reasons. Errors result in part from rounding when the changes in the 21 TABLE I IMPLIED PRICE AND COST INDEX NUMBERS (1970 = 100) Period Employ Income Profit Per Net Indirect Import GNE Per Unit of Unit of Tax Rates Prices Price Output...