Service Inflation: Why Is It Higher? - ARCHIVED

Since 1961, the service component of the Canadian Consumer Price Index (CPI) has generally shown a higher rate of increase than the goods component. Furthermore, when some of the more volatile components of the CPI are removed the spread widens. For instance, during the same period core goods inflation (excluding food and energy) increased at an annual rate of 4.3% compared to 6.1% per cent for services (excluding shelter). The literature on service sector inflation suggests five explanations for this phenomenon. Although all these sources of the inflation differential are interesting and important in their own right, this paper will examine two. Some believe that service inflation is a statistical artifact stemming from the inherent difficulties in measuring the output of services and hence their price changes. This issue will be examined first. Indeed the measurement problem appears more serious for services; however it cannot be held completely responsible for the inflationary gap. William Baumol (1967) originally suggested the other cause for higher service inflation whereby unbalanced sectorial growth would be the cause of the divergent inflation rates. This explanation will be the focus of the second part of the paper. In spite of the attractiveness of Baumol's model, empirical evidence rejects the hypothesis.