THE RELATIONSHIP BETWEEN CONSUMER PRICE INDEX (CPI) AND PRODUCER PRICE INDEX (PPI) IN

MALAYSIA

Linda Then Wee Mei

Corporate Master in Business Administration 2011

I Pusat Khidmat Maklumat Akademik UNIVERSITI MAlAYSIA SARAWAK

P.KHIDMAT MAKLUMAT AKADEMIK

111111111 IIi'rni 111111111 1000246504

THE RELATIONSHIP BETWEEN CONSUMER PRICE INDEX (CPI) AND PRODUCER PRICE INDEX (PPI) IN

MALAYSIA

LINDA THEN WEE MEl

A dissertation submitted in partial fulfillment of the requirements for the degree of Corporate Master in Business Administration

Faculty of Economics and Business UNIVERSITI MALAYSIA SARA W AK

2011

APPROVAL PAGE

I certify that I have supervised and read this study and that in my opinion it confirm to

acceptable standards of scholarly presentation and is fully adequate, in scope and quality, as

a research paper for the degree of Corporate Master in Business and Administration.

Dr. Evan Lau Poh Hock

Supervisor

This research paper was submitted to the Faculty of Economics and Business, UNIMAS and

is accepted as partial fulfillment of the requirement for the degree of Corporate Master of

Economic and Business.

Prof. Dr. Shazali Abu Mansor Dean, FEB

UNIMAS

11

I DECLARATION AND COPYRIGHT

Name : Linda Then Wee Mei Metric number: 09031603

I hereby declare that this research is the result of my own investigation, except where

otherwise stated. Other sources are acknowledged by footnotes giving explicit reference and

a bibliography is appended.

~(1~ . Signature Date :lit} 0&1)0/1

© Copyright by Linda Then Wee Mei and UNIVERSITI MALAYSIA SARA W AK

HI

I WORDS OF ACKNOWLEDGEMENTS

First of all, I would like to thank my supervisor, Dr. Evan Lau for him guidance

throughout the process of writing the research paper. He constantly motivates me to keep on

working on the research paper even though there are times at which I feeJ like giving up on

the research paper.

My word of gratitude also goes out to all my friends and course mates from UNIMAS

for their moral support and encouragement. Without them, this research would not be made

possible. At the same time, I would like to thank my wonderful parents who have always

motivated me to write this research paper until its very end.

On the whole, I would like to thank anyone and everyone (whom I cannot list out in

this acknowledge page) for their moral support and financial support.

Once again, thank you very much for all your helps. I appreciate it very much!

THANK YOU!

IV

ABSTRACT

(:he purpose of this research is to investigate that the relationship between producer price

index (PPI) and consumer price index (CP1) in Malaysia. In contrast with previous studies,

many information of the PPI to be useful forecasts improve to the CPI. The research use

monthly data of consumer price index (CPO and producer price index (PPI) from period

January 1986 to December 20 1~ The unit root test and Johansen co integration test is used

to investigate the transfer of change from consumer price index and producer price index, or

in other words to test the existence or not of a long-term relationship between the two

variables. Granger Causality test to find that there is uni-directional or bi-directional

causality between the PPI and CPI. The result shown that policy makers to rely more on the

link to between CPI and PPI and use changes in PPI to predict changes in CPI.

Keywords: Consumer price index; Producer price index; Unit root; Co-integration; Granger

causality

v

I

TABLE OF CONTENT

NO. ITEM PAGE Preliminary Pages • Title Page • Approval Page • Declaration & Copyright • Words of Acknowledgement • Abstract • Table of Content • List ofTable • List of Figures

1. CHAPTER ONE 1.0 Introduction 2 1.1 The Trend of Consumer Price Index and Producer Price Index 6 1.2 Conceptual framework of CPI and PPI 8 1.3 Problem Statement 11 1.4 Objective of Research 13 1.5 Significant of Study 14 1.6 Scope of Study 15 1.7 Organization of Chapters 16

2. CHAPTER TWO 2.0 Introduction 17 2.1 Review ofConsumer Price Index (CPI) 19 2.2 Review of Producer Price Index (PPI) 27 2.3 Review of Relationship between CPI and PPI 30 2.4 Summary 37

3. CHAPTER THREE 3.0 Introduction 43 3.1 Theoretical Framework 43 3.2 Research Design 44 3.3 Source Data 45 3.4 Methodology 45 3.5 Unit Root Test 45

3.5.1 Augmented Dickey-Fuller (ADF) 46 3.5.2 Philips-Perron(PP) 47

3.6 Cointegration 48 3.6. r The Johansen and Juse ius(l990) 50

3.7 Granger Causality 51 3.8 Summary 52

vi

TABLE OF CONTENT

NO. ITEM 4. CHAPTER FOUR

4.0 Introduction 4.1 Unit Root Test

4.1.1 Augmented Dickey-Fuller (ADF) and Philip-Perron (PP) 4.2 The Johansen Cointegration Test 4.3 Granger Causality Test 4.4 Summary

5. CHAPTER FIVE 5.0 Introduction 5.1 Conclusion from the research 5.2 Policy Implementation 5.3 Limitation and recommendation for future study 5.4 Summary

6. REFERENCES

PAGE

54 54 54 56 58 61

62 62 65 68 69

70

vii

LIST OF TABLES

TABLE DESCRIPTION PAGE Table 1 Review of Consumer Price Index (CPI) 24 Table 2 Review of Producer Price Index (PPI) 29 Table 3 Review of Consumer Price Index (CPI) and Producer Price Index (PPI) 38 Table 4 Unit Root Test (Level) 55 Table 5 Unit Root Test (First Difference Level) 55 Table 6 Johansen and Juselius Cointegration Test Result 57 Table 7 Result of Granger Causality Test 59

LIST OF FIGURES

FIGURE DESCRIPTION PAGE

Figure 1 The Trend of Consumer Price Index in Malaysia, 1970-2010 6 Figure 2 The Trend of Producer Price Index in Malaysia, 1970-2010 7 Figure 3 Theoretical Framework - Relationship between CPI and PPJ 43 Figure 4 Summaries of Methodologies used to examine the Relationship CPJ and PPI 53

Vlll

CHAPTER ONE

INTRODUCTION

r.

1.0 lntroduction

In Malaysia, stock market barometers of the national economy, CPI and PPI as

the core indicators of economic performance, on the national economy and capital

markets have a profound impact. Thus, Consumer price and producer price focused on

have been primarily focused on trying to gauge the growth in the economy which is

designed primarily to gauge the level of price stability in the economy.

Consumer Price Index (CPI) is similarly to a cost of living (Triplett, 1999). CPI

is one of the most important economic indicators in any country. It is uses for

measurement of the rate of inflation, for indexation of public pension benefits and for

many policy purposes (Takanobu, 2000). The Consumer Price Index (CPI) provides

data on the month-over-month and year-over-year changes in the prices paid by urban

consumers for a representative basket of goods and services (Yusoff, 2000). It is the

main inflation report for the futures and financial markets. Unexpected rises in this

indicator usually lead to falling bond prices, rising interest rates, and increased market

volatility.

cpr is a price index of measuring changes through time in the price level of

consumer goods and services purchased by household. (Boskin, Dulberger, Gordon,

Giliches & Jorgenson, 1998). Besides that, it calculates by national statistical agencies.

CPI is designed to provide broad measures of changes in retail price experienced by

Malaysian households as a group and should not be expected to exactly reflect the

2

experience of any individual household (Yusoff, 2000). Consumer prices are important

because consumer buying drives in the economy.

CPl also examines the weighted average of prices of a basket of consumer

goods and services, such as transportation, food and medical care. The CPl is

calculated by taking price changes for each item in the predetermined basket of goods

and averaging of the goods are weighted according to their importance. Changes in

CPI are used to assess price changes associated with the cost of living (Yusoff, 2000).

In the United States the major indexes of the seven points of goods, including are food,

wine and drinks house, Dress, Traffic, Medical health, Entertainment, Other goods and

services.

CPJ index is very important, but must be cautious with revelatory, because

released this index rose, the currency market, sometimes the opposite. Because the

consumer price index levels that consumer purchasing power, also reflects the

economic boom. When the country's consumer price index rising, shows that the

country's rising inflation, which is the buying power of a currency weakens, according

to the theory of purchasing-power parity, the country's currency should go weak. But

various countries to control inflation which inflation rising interest rates raise effect of

the opportunity and instead of the good. Conversely, when the country's consumer

price indexes show as inflation which is the buying power of a currency rises, the

country's currency should be stronger. When inflation under control and tends to

decline, interest rates will decline, instead of the light in this region.

Producer Price Index (PPl) was known as Wholesales Price Index (WPI) is

reported by many countries and is considered economic indicator. The PPJ index is a

3

good predictor of future value of the CPI. In fact, a rise in the PPI index indicates that

retailers are buying goods and commodities at a higher price. This increases costs and

consequently will raise the price of the products see and this will be reflected in the

CPI Index (Hamid, Dhakar and Thirunnavukkarasu, 2006).

PPI is the indicator of inflation each month. It is published by the u.s

Department of Labor in Bureau of Labor Statistics'. It measures the average change

over time in the selJing process received by domestic producers for their output. The

price included in the PPI is from the first commercial transaction for many production

and some services, those paid by importers for importing goods in Malaysia.

The PPI publication includes data on the month-over-month, quarter-over­

quarter. and year-over-year changes in PPI Data of PPI is included three categories of

production, which are finished good, intermediate goods and material. The

classification used for the in PPJ included Standard International Trade Classification2

(S.I.T.C), National Account System 3 , and International Standard Industrial

Classification4 (I.S .I.C)4.

Therefore, the producer price index is also leading inflation index, when the

production of raw materials and semi-finished goods prices, after several months, will

be reflected in prices of consumer goods and on the overall price level rise, cause

inflation (Hakkio, 2008). Conversely, when the index drops, production material price

in the production process will decline to effect overall price level fall down, abate

I Bureau of Labor Statistics is the principal fact-finding agency for the U.S government in broad field of labor economics and statistic. 2 tandard International Trade Classification is a classification of goods used to classify the exports and imports of a country to enable comparing different countries and years maintained by United Nation. 3 National Account System is the internationally agreed standard set of recommendation to compile measures of economic activity. 4 International Standard Industrial Classitication is United Nations system for classifying economic data.

4

Pusat Khidmat Maklumat Akadcmik UNlVERSlTI MALAYSIA SARAWAK

inflationary pressure. However, the data to include some commercial discount, unable

to fully reflect the real price rises will be exaggerated effect. In the foreign exchange

market, traders are concerned about the index. If the producer price index is expected

to higher inflation, the central bank may implement tighter monetary policy of the

currency, the favorable effect good. If the producer price index fell down, the opposite

effect.

5

1.1 The Trend of Consumer Price Index and Producer Price Index

Figure 1: The Trend of Consumer Price Index in Malaysia, 1970-2010

I:~ex . I 120

100

80

60 -+-CPI

40

20

o _.-'-' ---·~--·-·"----'i--·--···~--···--I-----r-----'---i

Year1970 1975 1980 1985 1990 1995 2000 2005 2010

--------------------------------------------------------~

Sources: Department ofStatistic Malaysia.

The Consumer price index in Malaysia was reported at 111.46 in 2008,

according to the World Bank. The consumer price index (CPI), the main gauge of

inflation to reflects changes in the cost to the average consumer of acquiring a basket

of goods and services that may be fixed or changed at specified intervafs, such as

yearly. CPI to representative that of a group purchases of consumer goods, today more

than ever how much of a time.

The Laspeyres formula 5 is generatly used. Malaysia is a rapidly developing

economy in Asia. Malaysia, a middle-income country, has transformed itself since the

1970's from a producer of raw materials into an emerging multi-sector economy. The

Government of Malaysia is continuing efforts to boost domestic demand to wean the

economy off of its dependence on exports. Nevertheless, exports are particularly of

electronics to remain a significant driver of the economy.

S Laspeyres formula measures price changes in relation to the base period's market basket and fixes the market basket by holding the item in it constant.

6

Figure 2: The Trend of Producer Price Index in Malaysia, 1970-2010

- --_._--------------_._ -----_.._--,

Index

160

140

120

100 .. ,80

i -1-PPI60 I I

40 I

1 20 ! 0 ~ ---.-----r--~--~i.---~---~---r_--~

Year 1970 1975 1980 1985 1990 1995 2000 2005 2010

Sources: Department ofStatistic Malaysia_

The Producer price index in Malaysia was reported at 121_09 in 2008, according

to the World Bank_ The producer price index (PPI), the main gauge of inflation at the

wholesale level. Wholesale price index refers to a mix of agricultural and industrial

goods at various stages of production and distribution, including import duties. The

Laspeyres formula is generally used. Malaysia is a rapidly developing economy in

Asia. Malaysia, a middle-income country, has transformed itself since the 1970s from

a producer of raw materials into an emerging multi-sector economy. The Government

of Malaysia is continuing efforts to boost domestic demand to wean the economy off

of its dependence on exports. Nevertheless, for the exports are particularly of

electronics to remain a significant driver of the economy.

7

1.2 Conceptual framework of CPI and PPI

Consumer price index and producer price index are the measurement of

inflation. Policy maker use these two indices to predict future inflation. Inflation is

continuing rise in general price level. Besides, inflation is related to different level of

price because different price affect different people. Wherefore, consumers purchase

goods and services based on their affordable. Different level of income win purchase

different level of price goods and services.

Producer price index in measure of inflation show that increase in the PPI can

resulting increase in CPI. Producer price inflation defines that pressure put on

producers by the costs of their raw materials. This will cause to consumer price

changes. For example, when the price increase on raw material this will cause to

consumer price increase on the finished good. With this, producer could be "passed

on" as consumer inflation and absorb by profit or offset by increasing productivity.

Typically, PPI higher prices mean increased business, it will lead to increased

corporate profits; but if the lower price transmission adverse or highly competitive

market, the PPI is higher competitive field means that many companies wi n face

increasing cost pressures, thus affecting corporate profits, the operational stability of

the enti re economy will be tested.

Researcher Jones (1986) have proven on his study, changes in producer prices

lead or cause consumer prices as a result of changes in producer prices which are

passed on to consumers. From Jones (1986) concept, when producer prices changes

causaUty consumer prices change. Besides, from the Keynesians theory, it tends to add

8

a capital goods or asset price inflation to the standard measure of consumption goods

inflation. This theory shown, producer price inflation can lead consumer price inflation.

Producer price index is differs from consumer price index. Wherefore, the two

indices are similar in fashion. Change in the PPI will forecast a change in the CPI.

However, when the CPI show a change of a significantly different direction compared

to the PPI. The reason is the different of definition and uses of the two indices. PPI is

use to reduce the revenue streams to get the real picture of output, while the CPI is to

describe changes in the cost of living. Because of those differences, each uses prices

from a different set of products and services.

PPI and CPI is the difference in the timing of data collection. PPI uses primarily

a mail survey to respondents on a monthly basis. In contrast, the CPI collects price

from telephone or personal visits by BLS representatives to respondents do not return

PPI survey fonus on a timely basis, indexes reflect late reports and price corrections.

PPI indexes are considered final. When PPI indexes are first released, they are

typically based on a substantial portion of the total number of prices that will

eventually be received from respondents; hence, subsequent revisions are normally

minor while CPI does not routinely revise indexes.

On the other hands, PPI targets the price of goods on a specific date while CPI

prices are typically collected by the first 18 working days of each month. When a

pricing decision occurred it is possible that it would be reflected in the CPI prior to the

PPI. Prices for some product and service categories in the CPI are collected every

other month. Because CPI reflects the price movement for some items period. In the

PPI, all price quotations are collected monthly.

9

The conceptual and definitional distinctions of the PPI and CPI are consistent

with the uses of these two major economic indicators. The PPI is used to deflate

revenue to measure real growth in output in the economic while CPI is used to adjust

income and expenditures for changes in the cost of living. Furthermore, the CPI

includes services, imports, and sales taxes, whereas the PPI excludes them.

Distribution costs are included in the CPI but not in the PPI. Finally, the PPI includes

capital equipment and the CPI does not.

10

1.3 Problem Statement

Malaysia always put an effort to develop the economy, social, human rights,

ecological integrity and achievement of equity in order to achieve Vision 2020 6 .

Malaysia aims to become a developed and industrialized country by 2020.

The CPI has an extremely important social and economic significance, CPI

stable, full employment and GOP growth is often the most important socio-economic

objectives. The role of consumer price index (CPI) is more important significantly for

the development in Malaysia for the capital market. High inflation wi ll lead to

unoertain earnings prospects of listed companies to increase market risk. The majority

of investors in the capital market sources of funds, their cost of capital are expected to

depend largely on CPI. Rising CPI also often leads to the central bank to raise interest

rates, tightening money supply, reduce the money supply and other measures to

tighten monetary policy, which flow into reduction of capital stock funds for greater

returns, often accompanied by high inflation and therefore the stock market decline.

Besides that, producer price index (PPJ) is a significant factor to increase

Malaysia economic performance and to stimulate economic growth. Nowadays,

Malaysia had spent a lot on infrastructure, public goods and services, capital

investment and social facilities in term of short-term, medium-term and long-term

planning. It is represented that there is an interrelationship between consumer price

index and producer price index.

6 Vision 2020 is the nation to achieve a self-sufficient industrialized nation by the year 2020 by consider

under all three of the economic, social and environmental factors.

11

However, there are still remaining several problems, which keep unsolved.

Although the variables are correlated with GOP growth in Malaysia, but will the

further growth of consumer price index and producer price index will benefit GOP

growth in the short term and long term period. Consumer price index tends to spent

more on the operating and development towards the increasing trends for GOP in

Malaysia. Moreover, the producer price index had performed unsteady since 1970.

The producer price index was registered downturn trend for several years. Thus, it is

important for researcher to examine the relationship between consumer price index

and producer price index in order to causality both in the short-run and long-run.

12

1.4 Objective of tbe researcb

The general objective of this research is to examine the relationship between

consumer price index (CPI) and producer price index (PPI) in Malaysia for the year of

1980-2007.

The specific objective of this study:

1. To examine the short-run relationship between the dependent variable (consumer

price index) and independent variables (producer price index)

2. To examine the long-run relationshi.p between the dependent variable (consumer

price index) and independent variables (producer price index)

3. To examine the causality pattern between dependent variable (consumer price

index) and independent variables (producer price index)

13

I.S Significance of the Study

Towards achieving the Vision 2020 to become a developed nation, Malaysia

has invested heavily in all dimensions, include fully developed in terms of national

and social unity, economy, social justice, political stability, system of government,

qual ity of life, social and spiritual values, national pride and confidence.

From the study, it might benefit to the policy makers in the decision of making

process. A good management on macroeconomic variables might bring to the

economic growth rather than economic recession.

Thus, this study tends to analyze the understanding the link and relationship

between consumer price index and producer price index in Malaysia. By determining

the independent variables, the main variable wilt be pointed out to explain the major

contributor for short-run and long-run causality between consumer price index and

producer price index in Malaysia. Besides, these two indices are measurement of

inflation. It would be helpful and benefit for policy makers, analysts, traders and

investors to predict future inflation. This significance factor plays an important role

and indicator because it will bring fong-run effects in Malaysia. It might provide a

suitable guiding for government to better understanding on Malaysian economy.

This study also has the potential to determine the growth of GDP in the future

and finaUy will lead to the rapid economic growth in Malaysia. It also help the future

researchers to do further study that related to the economic growth and development in

Malaysia. The CPI and has an extremely important social and economic significance,

CPI stable, full employment and GOP growth is often the most important socio­

economic objectives.

14

1.6 Scope of Study

This research reveals the various definitions of CPI and PPI, background

historical and differs of CPI and PPI. More specifically, explore the conceptual

differences by various researchers. This research is to evaluate the links between CPI

and PPI by applying unit root test, test of cointegration and granger causality which

are becoming are more popular. It would be helpful and benefit for investors, analysts,

researcher and government of Malaysia to predict future trend of CPI and PPJ.

Furthermore, the research is to help investors, analysts, researchers and government of

Malaysia to know effect on CPI and PPI.

In additional, CPI and PPI are important to more accurate, reliable and credible

measure especially when the rate of inflation needs to be monitored. It will be

conducted to ensure that the scope and coverage of the indices continue to meet the

needs of users; the structure of the indices reflects the current activities of the industry

concerned; and the weights used continue to be representative of the industry

concerned.

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1.7 Organization of Chapters

This research is organized into six chapters. Chapter one provides a brief

introduction to the research including the trend of CPI and PPI, conceptual framework

of CPI and PPI , problem statement, research objective, significance of study and

scope of study.

Chapter two of this research will defines about the literature ofCPI and PPI by

various researchers. Differential between the CPI and PPI, theoretical framework, and

hypothesis will be included.

Chapter three will discuss about the data and methodology use in this research.

First section will explain about the research method in this research. The result will

obtain from the data analysis. The data analysis process and methodology shall be in

link with the hypothesis presented in chapter two. Secondary data will through by the

e-view to procedure for gathering data in second section.

Chapter four intends to show the overall finding and empirical result of the

research.

Chapter five contains the discussion, conclusion, recommendations and

implication of research. Strength and potential limitation of the research is included.

Besides, it also provides introduced direction for the future research final of this

chapter is the conclusion of overall research.

16