Inflation and the consumption ratio / R.K. Anstie, M.R. Gray and A.R. Pagan.

Abstract

The rise in the consumption ratio observed in Australia in the 1970s has puzzled many commentators. A number of explanations have been provided, the two most popular concentrating upon uncertainty and the effects of a high rate of inflation. The latter has been justified largely by the observed correlation between the consumption ratio and the rate of inflation, but some observers have been uneasy with this explanation as the transmission mechanism has not been well specified. In fact, in some quarters this scepticism has been so strong that the connection has been regarded as a very weak and unstable one. The present paper suggests that the correlation between inflation and the consumption ratio arises because the Statistician's definition of the denominator - household disposable income - is inadequate in the face of inflation. An ideal definition of income should incorporate the fact that households suffer capital losses and gains on assets and liabilities. These arise when interest rates fail to adjust sufficiently for inflation. The paper constructs such a series of income and finds that a consumption ratio formed with this definition is very much more stable; in particular over the year 1979-80 this adjusted consumption ratio was virtually identical to its counterpart in the period 1966/7 to 1972/3. A number of other features of existing work are examined in the present study. Firstly, the proposed framework demonstrates why previous studies achieved the results that they did. Secondly, an alternative explanation involving the growth in two-income families is rejected in preference to accounting properly for the capital gains and losses induced by inflation. Finally, the 'capital loss effect' is found to be strong and stable over time. A number of policy implications emerge from the study. One of these is that the traditional consumption ratio, by using a definition of income that Show more