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Prices and inflation

by Adolf Stroombergen

For most of the 20th century inflation control eluded New Zealand governments. Finance Minister Rob Muldoon tried freezing wages and prices, but with unintended results. A floating exchange rate and tight reins on interest rates slowed inflation from the 1990s.

Prices and the consumer price index

Price changes can be measured either generally, or relative to other prices. Price inflation or deflation is a widespread increase or decrease in prices.

A rise or fall in petrol prices due to an increase or disruption in supply is a relative price change, and does not of itself constitute inflation. But if an increase in the price of petrol leads to increases in freight costs, then in turn to higher prices for other goods and services, then to higher wage rates, and then still higher prices for goods and services, general price inflation has taken hold. This happened in New Zealand after the oil shocks of the 1970s.

Throughout the 20th century and in the early 2000s inflation was more common than deflation in New Zealand. But in the 19th century and during the depression of the 1930s the general level of prices fell.

Relative price changes

Changes in relative prices alter the price of one good relative to others. Such changes are caused by a wide range of factors, including disruptions to supply, shifts in consumer preferences and changes in productivity.

Since the Second World War changes in prices in New Zealand have usually seen prices rising, some more than others, rather than a mixture of price rises and price falls.

Economists see the price of a good or service as an opportunity cost – if people purchase one product, they forgo another one.

Consumer price index

In New Zealand the most important measure of rises in general prices (inflation), or falls in prices (deflation) is the consumer price index (CPI). The CPI measures the changes in the price of goods and services purchased by households.

Statistics New Zealand calculates the CPI by measuring the changing cost of a ‘basket’ of goods and services bought by a typical household. Weightings are attached to the price of each good. Goods that are bought frequently or in large quantities (such as electricity) have greater weight than goods bought infrequently (such as television sets).

Different types of households are affected by changes in price in different ways – for example changes in the price of baby food are not directly relevant to a household of pensioners. The CPI relates to all households collectively, rather than to any particular type of household.

Other price indices are also used in New Zealand. Instead of measuring price inflation faced by households, some measure inflation faced, for example, by farmers, exporters or hospitals. However the CPI has been recorded since 1949, and in 2009 was still the most widely reported measure of price changes.

Price falls and rises, 19th and 20th centuries

Money and inflation

For most of the 19th and 20th centuries movements in prices in New Zealand reflected, or were an adaptation to, world trends. Until the mid-1890s there were many years of falling prices. Prices fell by 11% in 1870.

In contrast the 20th century was a century of inflation, though with two major interruptions – the early 1920s and early 1930s depressions, when prices fell by around 10% in some years.

The difference between the 19th and 20th centuries is partly explained by the fact that prices are affected by money supply. When the volume of money is limited, but available goods and services increase, prices tend to fall. Conversely when the quantity of money increases, prices tend to rise.

For much of the 19th century the government tied the volume of money in circulation to the amount of gold in circulation (known as the gold standard). Increases in gold did not keep pace with the increase of goods and services, and this led to price falls.

But in the 20th century governments often financed their own activities, or maintained levels of national economic activity, by creating more money – which caused price rises. This was especially the case during the two world wars.

After the Second World War the United States dollar was the most influential world currency. From the early 1960s the US financed its trade deficit by printing more dollars. This raised prices in many economies, including New Zealand’s.

1970s and 1980s inflation

A massive oil price increase in 1973–74 further exacerbated inflation in New Zealand. But the persistence of inflation into the late 1980s was primarily because of policies that allowed more money to be made available, so the overall level of prices rose. Between 1971 and 1988 inflation fell below 10% in only 4 out of 17 years, and exceeded 15% in 5 years.

Controlling inflation

Controlling prices in the 20th century

Through the 20th century the New Zealand government made many efforts to stop prices rising.

A 1910–11 enquiry into the cost of living analysed 69 family budgets. In 1912 a royal commission investigated the rise in the cost of living. It attributed the rise to excessive increase in the money supply, and thought that could best be countered by promoting economic efficiency. In 1916 a Board of Trade was set up to control wartime price rises, but it was dismantled during a price slump in 1921–22.

Measuring prices

The first efforts to measure the overall rise in prices in New Zealand were made by J. W. McIlraith, a school inspector. His pamphlet ‘The course of prices in New Zealand’ was published in 1911. Price rises began to preoccupy governments because they affected living standards, and so from the late 1930s the government itself compiled price indices.

During the Second World War the government pursued ‘stabilisation’ policies, in which it had to approve all price and wage increases.

Prices, 1960s to 1980s

In the late 1960s and early 1970s the government experimented with income policies to control wages, and regulate prices on some essential goods. In the late 1960s there was a consumers’ campaign against rising prices. Minister of Trade and Industry Warren Freer introduced a maximum retail price scheme in 1974.

None of the government strategies were successful. Goods not available at the allowed price were sometimes available through a black market, and schemes that had weak or no powers were ineffective.

In the late 1970s high rates of inflation became normal – ‘inflation accounting’ was devised as a way of accommodating finance to inflation, rather than the other way round.

From 1982 to 1984 Minister of Finance Robert Muldoon imposed a freeze on all price and wage changes. This was designed to eliminate inflationary expectations – the widespread assumption that prices were always rising, which in turn made rises more pervasive.

It is possible that if the price and wage freeze had lasted longer – a change of government put an end to it – it might have limited inflation. But problems with the freeze became obvious. In a high-inflation environment changes in relative prices were difficult to discern – prices were frozen at an arbitrary date and relative price changes were disguised. If relative prices are unclear, resources can be allocated to where they would be less productively used, and this leads to lower economic growth.

Reserve Bank Act 1989

In the 1980s the Labour government reformed the New Zealand economy. With the passing of the Reserve Bank Act in 1989 the government aimed to match the low inflation rate of its trading partners and achieve price stability. The act made the maintenance of price stability the bank’s primary purpose. The government took responsibility for setting an inflation target, and the Reserve Bank had to use its tools to meet that target. Until December 1996 the target was a 0–2% annual increase in the consumer price index (CPI), and then it was increased to 0–3%.

The Reserve Bank’s key tool in the control of inflation was its ability to set the official cash rate (OCR), the interest rates which banks have to pay to borrow money overnight. When the Reserve Bank raised the OCR, bank interest rates rose, and eventually this led to a reduction of other household spending, and of business investment activity.

Between 2003 and 2008 the Reserve Bank set a high rate, and subsequent high interest rates in New Zealand caused international demand for New Zealand dollars, as investors sought to take advantage of high investment interest rates on offer. As a result the value of the New Zealand dollar rose. Inflation was controlled, but prices for both exports and locally produced goods sometimes became uncompetitive.

Reduced inflation

The industrialisation of China and imports of relatively cheap manufactured goods helped reduce inflation. But other major factors which had an effect on the inflation rate in the early 2000s were:

  • reduced import protections and tariffs from the late 1980s
  • deregulation of the labour market, which reduced wage pressures
  • lower personal taxes and introduction of a goods and services tax.

Competition policy also made a difference. The deregulation of industries such as taxis and air travel, and the exposure to competition of industries such as clothing manufacture and telecommunications, all helped to reduce price inflation.

However rises in government charges, such as a petrol excise tax, increased the CPI, which fed through to higher wages and were an inflationary pressure.

Changes in relative prices

In the early 2000s inflation was generally low, but overall figures hid some substantial changes in relative prices. The prices of cars, clothing, computers and telephone services rose much less relative to the prices of food, household energy and local government property rates, according to New Zealand’s consumer price index (CPI).

Although new car prices rose between 1999 and 2008, the CPI showed they fell 7.2%, because, like all price indices, the CPI adjusts prices for quality changes – buyers got more for their money in the form of improved fuel efficiency, safety features such as airbags and anti-lock brakes, and air conditioning.

Tradable and non-tradable items

Economists often classify goods and services as tradable or non-tradable items. In broad terms goods and services that are internationally traded in mostly competitive markets (like cars) are ‘tradable’, and those that are not (like New Zealand electricity) are ‘non-tradable’. Non-tradable goods and services tend to be dominated by local suppliers with substantial market power. They are not restrained from raising their prices by international competition.

Between 2000 and 2002 price increases for tradable goods were greater than those for non-tradable goods. But on average the price of tradable goods and services rose by less than the price of non-tradable goods and services in the early 2000s. Between 1988 and 2008 the price of non-tradable goods rose by 115%, compared to only 32% for the price of tradable goods.

Producers’ prices

The CPI is the main measure of price inflation, but it is specifically designed to relate to a ‘basket’ of goods and services consumed by households. Other measures of price inflation include:

  • the producers price index (PPI) for inputs, which measures the cost of inputs of raw materials, energy and other ‘intermediate’ inputs purchased by businesses (but not the cost of the ‘primary’ inputs of land, labour and capital)
  • the PPI for outputs, which measures the price of goods and services produced by businesses.

In New Zealand the PPI for inputs and the PPI for outputs have tended to move in parallel. But between 1988 and 2008 the PPI for outputs rose by 69.1%, whereas the PPI for inputs rose by 76.1%.

Price of labour and capital

Price of labour

Changes in the price of labour – of wages and salaries – have been measured since 1993 by the labour cost index (LCI).

Between 1993 and 2008 the LCI rose by 37.5%, compared to a rise in the producers price index (PPI) for outputs – which measures the price of goods and services – of 41.5%. The change in the consumer price index (CPI) in this period was 39.5%. This shows that the relative cost of labour for businesses fell slightly over the period, and that the buying power of wages and salaries failed to keep pace with the prices of goods and services purchased by households.

Purchasing power

However the changes in LCI, PPI and CPI between 1993 and 2008 do not necessarily imply that New Zealanders were worse off over that time. The adjusted LCI is not a good guide to changes in the purchasing power of wages and salaries over time. This is because the LCI is an index and adjusts the price of labour for quality changes in workers’ qualifications and experience, and to changes in the quality of work required.

A new worker entering an existing job position is generally treated as a ‘quality’ change by the LCI – any associated wage change does not register. But obtaining a wage rise as they move between companies, or between positions within companies, is one of the main ways people increase their pay, and excluding these movements leads to a downward bias in the adjusted LCI.

A better guide to how the purchasing power of wages changes is to compare the CPI with average hourly earnings (AHE). Unlike the LCI, AHE makes no adjustment for the quality of labour.

Between 1988 and 2008 the increase in AHE was 93.6%, compared to an increase in the CPI of 65.1% – the purchasing power of hourly earnings increased by 17.2%, or about 0.8% per year.

Price of capital

Interest rates are the price people pay for ‘capital’ – money to invest. If a firm has to borrow funds to purchase buildings or equipment, the price of those funds is the interest rate at which the firm borrows. If it secures funding through inviting investors to subscribe to bonds or shares, it usually has to pay its investors at least what they could obtain by depositing their money in a bank account – investment in business is generally more risky.

Interest rates vary with:

  • different loan or investment periods
  • the amount borrowed or invested
  • the assessed creditworthiness of the borrower.

They also vary in different business cycles, and are significantly affected by monetary policy. Nevertheless, over a long period various interest rates tend to track each other quite closely.

In New Zealand the margin between the six-month deposit rate (the interest that the bank pays to those who take out a savings bond for a six-month term) and the variable first mortgage rate for housing loans has averaged about 2.5 %. This is the margin between borrowing rates and lending rates which banks retain, and earn much of their income from. The margin between the rates narrowed after the 1990s as banks earned more of their income from fees and other service charges.

Terms of trade and the exchange rate

Two measures of the ways in which price changes for New Zealand goods and services intersect with world prices are the terms of trade and the exchange rate.

Terms of trade

The terms of trade index is calculated by dividing the index of prices New Zealand receives for goods it exports, by an index of prices New Zealand pays for goods it imports. This gives a clearer picture of the balance of imports and exports, for example the number of tonnes of butter or timber that New Zealand has to export in order to import a bus or a barrel of oil.

Terms of trade directly affect New Zealanders’ standard of living. When the terms of trade fall, more products have to be exported to pay for imports – either less production is available for domestic consumption, or imports have to decline. There was a sharp decline in the terms of trade after the oil price shock in the early 1970s, and the terms of trade only returned to the 1957–74 average in 2008. In the early 2000s the terms of trade were more stable than in previous decades.

Exchange rate

The exchange rate is the price – or rate – at which the New Zealand dollar is exchanged for other currencies. It is expressed either as the number of foreign currency units that $1 can buy, or as the number of New Zealand dollars that are required to buy one unit of a foreign currency. In August 2008 NZ$1 bought 38 British pence, so it cost about $2.63 to buy one British pound.

Floating exchange rate

Until the 1980s New Zealand currency was fixed by the government, usually relative to the British pound. When the price of a currency is fixed, changes in its real value may be masked. Prices send signals to buyers and sellers about the relative value of goods and services, and when currency is fixed signals of changing values can be obscured.

In 1984 the government decided to allow the dollar to float, which meant its price in other currencies was determined by market demand. The intention was to align the price of currency with most other items that were bought and sold commercially, be it hotel rooms, concert tickets, cars, or fruit and vegetables. The risk of an unregulated market for a currency is that it can become the object of speculation – people buy when the value is low and hope to sell when it is high, transactions which are independent of the currency’s value in the real economy.

In the early 2000s the New Zealand dollar was readily exchanged with a large number of other currencies, but the most commonly traded ones were the Australian dollar, the American dollar, the European euro, the Japanese yen and the British pound – all currencies of New Zealand’s major trading partners.

In general the rate of exchange with these currencies moved up or down in parallel, but the exchange rates with the Japanese yen and the American dollar were more volatile.

Trade weighted exchange rate index

To find the international price of New Zealand currency economists weight the various exchange rates by their share of New Zealand international trade. This is known as the trade weighted exchange rate index (TWI).

Between 1974 and the early 1990s the TWI declined steadily. The main cause was the higher rate of price inflation in New Zealand compared to its major trading partners – changes in the exchange rate neutralised the effects of differences in relative inflation rates, more or less maintaining the international competitiveness of New Zealand goods, but meaning New Zealanders had to pay high prices in New Zealand currency for overseas goods or for foreign travel.

After 1993 the exchange rate for the New Zealand dollar strengthened, and prices for imported goods such as cars and clothing lowered. This meant lower domestic price inflation. The exchange rate is one of the main mechanisms by which governments can control inflation.

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How to cite this page: Adolf Stroombergen, 'Prices and inflation', Te Ara - the Encyclopedia of New Zealand, (accessed 23 April 2019)

Story by Adolf Stroombergen, published 11 Mar 2010