HCA should not be implemented during high inflation and hyperinflation

HCA should not be implemented during high inflation and hyperinflation

IAS 29 states: The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, whether they are based on a historical cost approach or a current cost approach shall be stated in terms of the measuring unit current at the end of the reporting period. IAS 29, Par 8.

PricewaterhouseCoopers states the following regarding the use of the HCA model during hyperinflation:

Inflation–adjusted financial statements are an extension to, not a departure from, historic cost accounting.

Financial Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006, p 5.   

It is clear from the above that IFRS approve and PricewaterhouseCoopers support the implementation of the Historical Cost Accounting model which includes the very erosive stable measuring unit assumption during high inflation and hyperinflation. That is a fundamental mistake during high inflation and hyperinflation. HCA should not be implemented during high inflation and hyperinflation

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Financial capital maintenance in units of constant purchasing power in terms of a daily rate or index is required

Financial capital maintenance in units of constant purchasing power in terms of a daily rate or index is required

I regard the requirement of financial capital maintenance in units of constant purchasing power in terms of a daily rate during high and hyperinflation in future review of IAS 29 as the most pressing financial reporting need for standard-setting action from the IASB. That would quickly lead to its implementation during low inflation in terms of a Daily Consumer Price Index. The Unidad de Fomento in Chile and all inflation-indexed bonds (they trade daily) in many countries currently use DCPIs. A Daily Consumer Price Index is a lagged daily interpolation of the CPI. The Unidad de Fomento is a monetized daily indexed unit of account un-rebased since 1967 and published daily since 1977. The Central Bank of Chile publishes it daily since 1990.

The current implementation of financial capital maintenance in nominal monetary units (HCA) during low inflation results in the unnecessary erosion of vast amounts of constant item real value in the world´s constant item economy each and every year. (See the deficiency in capital during the financial crisis.) It is very clear that it is not possible to maintain the real value of capital in nominal monetary units per se during low inflation.

Financial capital maintenance in units of constant purchasing power in terms of a daily rate or daily index would automatically stop this erosion in constant real value by the stable measuring unit assumption (not low inflation, high inflation or hyperinflation) for an indefinite period of time during low inflation, high inflation and hyperinflation. It would instead maintain vast amounts of constant item real value in the world´s constant item economy per annum at the current level of world inflation when the stable measuring unit assumption is finally rejected in the measurement of constant items, e.g. shareholders´ equity at all levels of inflation and deflation.

Although the IASB authorized financial capital maintenance in units of constant purchasing power at all levels of inflation, high inflation, hyperinflation and deflation in the original Framework (1989), Par 104 (a) – any individual company implementing IFRS can implement it right now during low inflation and deflation –  and although the definitions of constant real value non-monetary items and variable real value non-monetary items are clearly implied in Par 104 (a), a definite requirement of only financial capital maintenance in units of constant purchasing power in terms of only a daily rate during high inflation and hyperinflation plus the actual definition of constant real value non-monetary items and variable real value non-monetary items in a revised IAS 29 would, in my opinion, quickly lead to the implementation of financial capital maintenance in units of constant purchasing power in terms of a Daily Consumer Price Index during low inflation and deflation.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

IAS 29 does not affect the operations of a company during hyperinflation

IAS 29 does not affect the operations of a company during hyperinflation

          IAS 29´s ineffectiveness during hyperinflation was undeniably demonstrated during the last 6 years of hyperinflation in Zimbabwe. IAS 29 was required for Zimbabwean companies listed on the Zimbabwean Stock Exchange as from 2002. IAS 29 made absolutely no difference to hyperinflation in Zimbabwe from 2002 till the end of hyperinflation on 20^th November, 2008.

         IAS 29´s ineffectiveness was very well summarized by Michael Madsen, the Group CFO of The East Asiatic Company Ltd., the Danish company with a subsidiary in Venezuela´s hyperinflationary economy in this Euroinvestor article:

       Accounting adjustment due to Venezuela now considered a hyperinflation economy. Irrespective of the devaluation, but due to the recent years' increased inflation in Venezuela the country should for accounting purposes be considered a hyperinflationary economy as of 31 December 2009. Under the International Financial Reporting Standards (IFRS) this requires the application of IAS 29, "Reporting in hyperinflationary economies" for 2009 and subsequent years.

        The application of the standard affects the accounting presentation, but does not affect the operation or the cash flow.

http://www.euroinvestor.co.uk/news/story.aspx?id=10821702

       How is it possible that the implementation of IAS 29 in a hyperinflationary economy does not affect the operation of a company?

        IAS 29 is ineffective because simple restatement of Historical Cost or Current Cost financial reports in terms of the period-end Consumer Price Index does not make any difference during hyperinflation as stated by Mr. Madsen and very well proven in Zimbabwe.

        IAS 29´s very clear ineffectiveness during hyperinflation as well as IAS 29 restated financial reports available on the internet with unbelievable and thus irrelevant ratios also damage the otherwise very excellent and highly respected reputation of the IASB and the image of IFRSs.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Strengths of the CIPPA approach compared to IAS 29 during hyperinflation

Strengths of the CIPPA approach compared to IAS 29 during hyperinflation

The competition is IAS 29.

CIPPA during hyperinflation is financial capital maintenance in units of constant purchasing power by means of daily measurement of all non-monetary items in terms of a Brazilian style daily index or the daily US Dollar parallel rate versus simple restatement of HC or CC financial reports in terms of the period end monthly CPI as required by IAS 29.

Strengths of the CIPPA approach

1.    It automatically maintains the constant purchasing power of capital constant forever in all entities that at least break even in real value during hyperinflation – ceteris paribus: more or less what Brazil did during 30 years of daily indexing of all non-monetary items from 1964 to 1994 (completely ignored by the IASB).

2.    It can right now be implemented by any individual company during hyperinflation. However, it is not yet authorized in IFRS during hyperinflation. IFRS require the implementation of IAS 29 during hyperinflation. Although authorized in IFRS in the original Framework (1989) Par 104 (a), IAS 8.11 states that a specific standard takes precedence over the Framework.

3.    It can be used to eliminate the effect of hyperinflation from the entire money supply - zero inflation - (excluding from actual bank notes and coins which generally make up about 7% of the money supply) only in the case of complete coordination with all money and other monetary items inflation-adjusted daily in terms of a Daily Index or daily US Dollar parallel rate during hyperinflation.

Strengths of IAS 29

No strengths.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Strengths of CIPPA compared to HCA during LOW inflation

Strengths of CIPPA compared to HCA during LOW inflation

1.    It automatically maintains the constant purchasing power of capital constant forever in all entities that at least break even in real value during LOW inflation and deflation – ceteris paribus.

2.    It is also authorized in IFRS – in the same sentence.

3.    It can right now be implemented by any individual company implementing IFRS.

4.    It can be used to eliminate the effect of inflation from the entire money supply - zero inflation - (excluding from actual bank notes and coins which generally make up about 7% of the money supply) only in the case of complete coordination with all money and other monetary items inflation-adjusted daily in terms of a Daily Consumer Price Index. Chile currently inflation-indexes 20 to 25% of its broad M3 money supply on a daily basis in terms of the Unidad de Fomento which is a monetized daily indexed unit of account.

Strengths of HCA

1.    It is the 3000-year-old generally accepted, globally implemented, traditional accounting model.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Monetary items under CIPPA

Monetary items under CIPPA

Financial capital maintenance in units of constant purchasing power during LOW inflation and deflation (CIPPA), under which the very erosive stable measuring unit assumption is rejected, requires the following:

        Monetary items inflation–adjusted daily

 All monetary items – historical and current period monetary items – are inflation–adjusted in terms of a Daily Consumer Price Index or monetized daily indexed unit of account like the Unidad de Fomento in Chile. This results in the complete elimination of the cost of inflation (not actual inflation in the unstable monetary unit); i.e. there would be no net monetary loss or gain in the entire economy (excluding in actual bank notes and coins), only under complete coordination and with all money in the banking system which makes this only a theoretical assumption. There are always bank notes and coins outside the banking system even if all other monetary items in and outside the banking system were inflation–indexed; as partially done in Chile since 1967 in terms of the UF – since 1990 on a daily basis.

         There would thus always be net monetary losses and gains to be calculated and accounted only in the monetary economy under CIPPA. Net monetary losses and gains are not calculated during low inflation and deflation under the current Historical Cost paradigm. In stark contradiction, they are required to be calculated during hyperinflation under the current HC paradigm in terms of IAS 29 Financial Reporting in Hyperinflationary Economies which requires the restatement of Historical Cost and Current Cost financial statements in terms of the period–end monthly CPI during hyperinflation. Inflation, deflation and hyperinflation have no effect on the real value of non–monetary items.

There are generally net monetary losses and gains during low inflation, deflation and hyperinflation under traditional generally accepted and globally implemented HCA. They are not calculated and accounted during low inflation and deflation in terms of IFRS and US GAAP under HCA. However, they are required to be calculated and accounted during hyperinflation in terms of IFRS as required by IAS 29. This is one of the various contradictions under HCA corrected under CIPPA. Under financial capital maintenance in units of constant purchasing power net monetary gains and losses are – very logically – calculated and accounted during low inflation, deflation and hyperinflation.

Complete coordination in implementing CIPPA in an economy would most probably not be that easy to achieve right from the start. Banks cannot be forced to inflation–adjust all monetary items in the banking system when entities do not yet understand all the benefits of inflation–adjusting all monetary items in an economy as well as financial capital maintenance in units of constant purchasing power as authorized in IFRS as far back as 1989. Chilean banks operate profitably with inflation–adjusting a portion (currently 20 to 25% of their broad M3 money supply) of deposits from clients since 1967. They inflation–index daily, for example, mortgages, car loans, student loans, consumer loans, business loans, personal loans, etc. which include their profit margins, to clients in terms of the UF.

Nevertheless, entities may start financial capital maintenance in units of constant purchasing power, as authorized in IFRS, without any inflation–adjustment of monetary items at all. They may be motivated by the invisible hand of self–interest, shareholder pressure or more financial crises caused by often undercapitalized banks and companies. They may wish to immediately benefit from automatically maintaining the constant purchasing power of their own shareholders´ equity constant forever as long as they break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. (See CIPPA increases a company´s net asset value.)

There is much to be gained from moving away from reporting on the basis of Financial Capital Maintenance in Nominal Monetary Units.

           Prof Rachel Baskerville, Associate Professor of Accounting at the School of Accounting and Commercial Law at the Victoria University of Wellington, New Zealand in her publication 100 Questions (and Answers) about IFRS,  Question 38, 2010 on the Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526846

The full cost of or gain from inflation – net monetary loss or gain – would be recognized by these entities in their operations. It would be calculated and accounted in financial reports prepared under CIPPA. Under partial inflation–adjustment of monetary items – e.g. in Chile, the US, UK, Canada and all countries issuing inflation–indexed sovereign and commercial bonds (see above) – the net monetary loss or gain would be calculated and accounted for the part not inflation–indexed; i.e., currently for the greater part of the money supply under CIPPA. This is presently not being done in Chile, the US, UK, Canada, etc. because these countries implement the HCA model under which net monetary losses and gains are not calculated and accounted during low inflation and deflation: they are, paradoxically, correctly required by the IASB to be calculated during hyperinflation under the same HC paradigm.

The calculation and accounting of net monetary losses and gains are required under CIPPA because the stable measuring unit assumption is never applied under financial capital maintenance in units of constant purchasing power during low inflation, deflation and hyperinflation.

The constant purchasing power of capital can automatically be maintained constant forever by the real value of net assets in entities that at least break even in real value during inflation and deflation – ceteris paribus – per se whether they own any revaluable fixed assets or not – only when they implement financial capital maintenance in units of constant purchasing power (CIPPA) because capital is equal to the real value of net assets as qualified. Financial capital maintained in nominal value by means of measurement in nominal monetary units is not equal to net assets in real value per se (always and everywhere) even though IFRS and US GAAP authorized financial capital maintenance in nominal monetary units (the HCA model) and although it is the 3000–year–old generally accepted globally implemented traditional accounting model used by all entities. Financial capital maintenance in nominal monetary units during inflation and deflation per se is a fallacy approved in IFRS.

Under HCA the cost of inflation in the monetary economy is not calculated and accounted because the books are not being balanced in real terms but in nominal monetary terms with the implementation of the very erosive stable measuring unit assumption under financial capital maintenance in nominal monetary units. The concept of capital being equal to net assets is also applied under HCA, but, in illusionary nominal monetary terms. Historical Cost illusion that it is possible to maintain the real value of capital in nominal monetary units per se during inflation and deflation makes Historical Cost Accounting a very erosive and – in principle – inappropriate accounting policy.

Entities, on the one hand, apply the stable measuring unit assumption under HCA in the valuation of their own shareholders´ equity in their own financial reports in nominal monetary units under which they may not take into account unreported hidden reserves for fixed assets not revalued when they apply the Historical Cost approach to the valuation of fixed assets in terms of IFRS. On the other hand, they always value third parties´ shareholders´ equity taking into account unreported hidden reserves for fixed assets not revalued, e.g. in the share price of listed companies which they value at market value in terms of IFRS, as well as in their valuations of unlisted companies.

This means that under HCA only entities with revaluable fixed assets (revalued or not) with an updated fair value equal to 100% of the updated constant real value of shareholders´ equity maintain the real value of their capital under the concept of nominal financial capital is equal to net assets measured in nominal monetary units during inflation and deflation. This may only be the case in hotel, hospital and other property–intensive entities. CIPPA maintains the constant purchasing power of financial capital constant forever in all entities that at least break even during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not. This requires the calculation and accounting of net monetary losses and gains as well as net constant item losses and gains (a new accounting term) because the books are being balanced in real terms; i.e. the stable measuring unit assumption is never applied.

This also means that, under HCA, the portion of shareholders´ equity never covered by sufficient revaluable fixed assets (revalued or not) has always been and is still – currently –  unnecessarily, unintentionally and unknowingly being eroded at a rate equal to the annual rate of inflation; not by inflation, but, by the implementation of the stable measuring unit assumption during inflation.

The erosion is equal to the annual rate of inflation because economic items are valued in terms of unstable money which is the legal unstable monetary unit of account and inflation erodes the real value of only unstable money and other unstable monetary items. Inflation has no effect on the real value of non–monetary items.

Shareholders´ equity is a constant real value non–monetary item. This unnecessary erosion in constant item real value by the implementation of the stable measuring unit assumption amounts to hundreds of billions of US Dollars per annum in the world´s constant item economy.

Financial capital maintenance in units of constant purchasing power during low inflation and deflation (CIPPA) would stop that forever and would instead maintain hundreds of billions of US Dollars per annum in the world´s shareholders´ equity investment base for as long as world inflation remains at the current level.

As the Deutsche Bundesbank so wisely stated:

The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.

Deutsche Bundesbank, 1996 Annual Report, P 83.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

CIPPA is a departure from HCA and inflation in non-cash monetary items

CIPPA is a departure from HCA and inflation in non-cash monetary items

CIPPA is a departure from

(1) HCA, i.e. the erosion of real value in constant items caused by the stable measuring unit assumption during inflation and

(2) the erosion of the real value of monetary items that are not bank notes and coins caused by inflation.

CIPPA eliminates the erosion of real value in constant items caused by the stable measuring unit assumption during inflation by means of financial capital maintenance in units of constant purchasing power as authorized in IFRS in terms of a Daily Consumer Price Index or a daily monetized unit of account, e.g. the Unidad de Fomento in Chile.

This automatically maintains the real value of shareholders´ equity constant forever in all entities that at least break even in real value during inflation and deflation – ceteris paribus. A company can do this while dealing with all third parties still implementing HCA.

Entities can only stop the erosion of the real value of their monetary items that are not bank notes and coins caused by inflation (no 2 above) when all third parties they deal with agree to inflation-adjust non-cash monetary items (complete coordination in an economy). Under CIPPA they would currently account the net monetary loss caused by inflation in their net monetary item debit balances in the profit and loss account during low inflation.

$2.68 trillion of global government bonds were daily inflation-indexed bonds as at the end of 2009. Chile currently inflation-adjusts 20 to 25% of its broad M3 money supply according to the Central Bank of Chile.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

A constant unit of account

A constant unit of account

         Theoretically a global perfectly stable unit of fixed constant real value would be equal to one monetary unit in a world economy in a global monetary union with a single currency under indefinite perfectly sustainable zero inflation.

In an ideal world, there would be one global currency subject to neither inflation nor deflation, nor political manipulation by any one or group of countries.

A constant unit of account, Richard W. Rahn, Cato Journal, Vol. 30, No. 3 (Fall 2010).

http://www.cato.org/pubs/journal/cj30n3/cj30n3–9.pdf

Neither of the two economic environments described above are very likely to be achieved. It is thus much more likely that a single unit of constant real value will come about via a global non–monetary index in a multi–currency world economy.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Daily Consumer Price Index – DCPI

Daily Consumer Price Index – DCPI

(i)          Introduction

      Unstable money is the unstable medium of exchange, unstable store of value and unstable unit of account in the economy. Pre–monetary economies had units of account without money being available in the economy. (See Robert J. Shiller, Indexed Units of Account: Theory and Assessment of Historical Experience, Cowles Foundation Discussion Paper No 1171, 1998, p4).

      Today the economic values of all economic items are stated in terms of unstable money. Prices are expressed in unstable monetary units. Unstable money is the generally accepted unstable monetary unit of account used to value and account all economic activity by entities applying the stable measuring unit assumption as part of the traditional Historical Cost Accounting model under which they implement financial capital maintenance in fixed nominal monetary units with unstable real values in the world economy during inflation, deflation and hyperinflation.

      Unstable money is not fixed in constant real value. Unstable money is fixed in nominal value in economies subject to inflation, deflation and hyperinflation. Unstable money is a fixed nominal unit of account with a daily changing real value (purchasing power).  Financial capital maintenance in nominal monetary units, although approved in IFRS and by the United States Financial Accounting Standards Board (US FASB) and implemented worldwide, is a very popular accounting fallacy not yet extinct because it is impossible to maintain the real value of capital in nominal monetary units per se during inflation and hyperinflation.

      Bank notes and bank coins cannot currently be inflation–indexed or deflation–indexed which makes it impossible for money or the monetary unit of account to be a perfectly stable unit of constant real value during inflation, deflation and hyperinflation.

(ii)          Unidad de Fomento

      Notwithstanding or despite the above, monetary items in the form of certain time deposits  – not the actual bank notes and coins – and other monetary items, e.g. certain government capital market bonds, have been inflation–indexed in Chile since 1967 by means of the Unidad de Fomento which is now a monetized daily indexed unit of account.

      The Central Bank of Chile translates the “Unidad de Fomento” on their website to An Inflation–Indexed Accounting Unit and CPI–Indexed Unit of Account (UF).

      The UF´s value in Chilean escudos was originally (1967) updated every quarter which would be the official rate for the following quarter. The UF´s original value of 100 has never been rebased like most CPIs. It was updated monthly from October 1975, with the currency changeover to pesos, till 1977. Since July 1977 it was calculated daily by interpolation between the 10th of each month and the 9th of the following month, according to the monthly variation of the Indice de Precios al Consumidor (IPC), the Chilean Consumer Price Index. The Banco Central de Chile has calculated and published the UF´s value daily since 1990. The UF is a lagged daily interpolation of the Chilean CPI. The IPC is independently calculated and published monthly by the Chilean National Statistical Institute.

      The UF daily rate is available on the Chilean Central Bank´s website.

      Most bank deposits in Chile are 30–day non–indexed deposits or 90–day indexed deposits whose rates are expressed in terms of the UFs. Interest rates on the indexed deposits are expressed as a premium over the UFs. On maturity, the deposits are converted back to pesos at the current UF rate. Shiller, 1998, p3.

(iii)          Definition: Daily Consumer Price Index

      Daily inflation–indexing monetary items is thus not a new concept. Chile is the country which is closest to inflation–indexing its entire money supply. 30–Day deposits are not currently inflation–indexed in Chile.  90–Day deposits and various other monetary items are inflation–indexed daily resulting in 20 to 25% of Chile´s broad M3 money supply being inflation–indexed on a daily basis in terms of the UF according to the Banco Central de Chile.

        The Consumer Price Index is an example of a non–monetary general price level index. The annual percentage change in the CPI indicates the annual rate of inflation. The CPI for a particular calendar month is normally published in the second or third week of the next calendar month.

        A daily instead of a monthly general price–level index is required to implement financial capital maintenance in units of constant purchasing power during inflation and deflation (Constant Item Purchasing Power Accounting). Using the CPI published monthly may result in sudden increases or decreases in values on the date the new monthly CPI is published. A Daily CPI, which is a lagged daily interpolation of the monthly–published CPI, solves this problem. The UF is a very successful monetized daily indexed unit of account used in Chile during the last 44 years and was copied by Ecuador, Mexico and Columbia. (See Shiller, 1998, p6.)

      Financial capital maintenance in units of constant purchasing power during hyperinflation would require measurement in either a daily parallel hard currency exchange rate – normally the daily US Dollar parallel rate – or a Brazilian style Unidade Real de Valor daily non–monetary index primarily based on the US Dollar daily parallel rate. The URV was an excellent daily non–monetary index published by the government during hyperinflation in Brazil because it was mainly based on the US Dollar parallel rate (a hard currency parallel rate is essential during hyperinflation which is an exceptional circumstance according to the IASB), but, the CPI was also included in the formula.

        Implementing IAS 29 does not result in financial capital maintenance in units of constant purchasing power during hyperinflation. IAS 29 simply requires restatement of Historical Cost or Current Cost financial statements in terms of the period–end monthly CPI during hyperinflation. Inflation–adjusted financial statements in terms of IAS 29 are not a departure from, but, an extension to HCA during hyperinflation.

Definition

           A Daily Consumer Price Index is a lagged daily interpolation of the CPI

 The DCPI is based on the formula to calculate the daily price of a government inflation–indexed bond in a particular country, e.g., the formula to calculate the daily price of TIPS in the US, or the formula used to calculate the Unidad de Fomento in Chile.

Every country which issues inflation–indexed government bonds has a Daily Consumer Price Index based on the respective CPI. In practice, a DCPI is used to inflation–adjust monetary items, to update historical variable items and to measure constant items in units of constant purchasing power on a daily basis under Constant Item Purchasing Power Accounting; i.e. financial capital maintenance in units of constant purchasing power during low inflation and deflation as authorized in International Financial Reporting Standards (IFRS) in the original Framework (1989), Par 104 (a).

       The Unidad de Fomento in Chile is the most successful monetized daily indexed unit of account to date.

       A DCPI is calculated and published daily, for example, the UF published daily by the Banco Central de Chile. The monthly published CPI for the first day of any month is only available – at the earliest – round–about the tenth of the next month: up to 41 days later. The SA CPI for the first day of a calendar month can become available up to the 24^th of the next calendar month: i.e. up to 55 days later. This is very impractical for daily financial capital maintenance in units of constant purchasing power.

(iv)        Formula

“The UF is now a lagged daily interpolation of the monthly consumer price

index. The formula for computation of the UF on day  t is:

                              UF t = UF t–1 × (1+ π) to the power 1/d

where π is the inflation rate for the calendar month preceding the calendar month in which  t falls if  t is between day ten and the last day of the month (and d is the number of days in the calendar month in which t falls), and π is the inflation rate for the second calendar month before the calendar month in which  t falls if  t is between day one and day nine of the month (and d is the number of days in the calendar month before the calendar month in which t falls).”  See Shiller, 1998, p3.

The above formula applies to the UF in Chile where the CPI for the current calendar month used to be available on the 10^th of the next calendar month. The general case formula for a UF–based DCPI is stated as follows:

On day t   

                                     DI t  = DI t–1  X  (1 + π) to the power 1/d

where π is the monthly inflation rate for the second calendar month before the calendar month in which t  falls if t  is on or between day one and the day of publication of the CPI of the previous calendar month (and d  is the number of days in the calendar month before the calendar month in which t  falls), and π is the monthly inflation rate for the calendar month preceding the calendar month in which t  falls if t  is on or between the day the CPI for the previous calendar month is published and the last day of the month (and d is the number of days in the calendar month in which t  falls).

           The monthly inflation rate for a calendar month is calculated using the CPI for that month and for the preceding month. The DCPIs within a given calendar month thus depend on the CPI for each of the three preceding months. For example, the July DCPIs depend before the day the June CPI is published on the CPI for April and May, and starting with the day the June CPI is published on the CPI for May and June.

          A DCPI is very similar to, but, not exactly the same as a monetized daily indexed unit of account, e.g. the UF in Chile. The UF is monetized; i.e. it is stated in terms of the Chilean peso. That is not the case with a DCPI. A DCPI is not automatically monetized.

       “The UF was and is an amount of currency related to the Indice de Precios al Consumidor (IPC), the consumer price index for Chile.” (Shiller, 1998, p3)

       A DCPI is, like the monthly CPI on which it is based, a non–monetary general price–level index value. Monetization depends on generally accepted monetary practices in an economy: see the UF in Chile. A DCPI can be monetized and used as a monetized daily indexed unit of account with payments being made in the national monetary unit – depending on users in an economy. Monetization is not a necessity.

      “An exchange rate between the unit (the UF) and the true money or legal tender, in Chile the peso, is defined using an index number (such as the consumer price index), and payments are executed in money. Thus, the indexed units of account facilitate payments that are tied to the index number, without being a means of payment.”  (See Shiller, 1998, p2.)

       A DCPI is not a unit of account just like the CPI is not a unit of account for accounting purposes. The US Dollar, Euro, Yen, Yuan, etc are the nominally fixed monetary units of account, unstable in real value, used in their respective countries as the national unstable monetary unit of account for accounting purposes during inflation, deflation and hyperinflation. The US, EU, Japanese and Chinese CPIs are not units of account for accounting purposes. They are non–monetary general price–level indices. So are their DCPIs. Prices are not quoted in CPIs or in DCPIs – although they can be.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Consumer Price Index

Consumer Price Index

         The CPI is the weighted average index value of a typical basket of consumer goods purchased by a typical consumer statistically stated as a non–monetary initial index value of 100 at the start date. The CPI is thus fixed in real terms – not in nominal terms. It changes monthly in nominal terms, but, it stays fixed in real terms.

         An example is the harmonized consumer price index of the Euro Area stated as the non–monetary index value of 100 in 2005. This fixed internal unit of real value is then compared to the weighted average price of the typical basket of consumer goods and services a year later in order to determine the annual rate at which inflation is eroding the real value of only money and other monetary items in only the monetary economy or deflation is creating real value in only money and other monetary items in only the monetary economy. Inflation and deflation have no effect on the real value of non–monetary items. The same is true for hyperinflation.

            The stable measuring unit assumption (not inflation and hyperinflation) erodes the real value of constant items never maintained constant (never measured in units of constant purchasing power in a double–entry accounting model where the real value of capital is equal to the real value of net assets) during inflation and hyperinflation under the Historical Cost paradigm. Similarly, it is not deflation, but, the stable measuring unit assumption that creates real value in constant items never maintained constant (qualified as per the previous sentence) during deflation under HCA.

       The annual percentage change in the CPI indicates the annual rate at which only the real value of the national (or monetary union, e.g. the European Monetary Union) monetary unit (money) and other monetary items is being eroded by the economic processes of inflation and hyperinflation or being increased by the economic process of deflation.

Nicolaas Smith Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.