Causal Relationship Between Consumer Price Index and Producer Price Index: Using Vector Error Correct Model (VECM) and Granger Causality

The consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households. Consumer price index (CPI) is used for determining whether general prices are higher, lower or stable over time, calculating annual rate of inflation, and converting nominal values to real. A Producer Price Index (PPI) measures the average changes in prices received by domestic producers for their output. It is one of several price indices. Its importance is being undermined by the steady decline in manufactured goods as a share of spending. What is the causal relationship between PPI and CPI? Do producer prices cause consumer prices or consumer prices cause producer prices? There are two basic approaches about PPI and CPI causality relationship, namely supply side and demand side in literature (Akcay, 2011).According to supply side approach, PPI and CPI are connected by production chain. Advocates of supply side approach claimed that crude materials serve as inputs to the production of intermediate goods, which in turn serve as inputs to the production of final goods. Changes in prices of crude materials should pass through to prices of intermediate and final goods and ultimately to consumer prices (Clark, 1995, p.26). Therefore, changes in PPI lead or cause CPI. According to demand side approach ‘demand for final goods and services determines the demand for inputs between competing uses’. Thus, ‘the cost of production reflects the opportunity cost of resources and intermediate goods, which in turn reflects demand for the final goods and services’ (Caporale, Katsimi and Pittis, 2002, p.705). Consequently, consumer prices can affect producer prices (Akcay, 2011).The causality between PPI and CPI remains a controversial issue in empirical findings. There are three different empirical evidences about PPI and CPI nexus, namely one way, two-way and no causality in literature (Akcay, 2011). There are many studies examining the directions of causality between Producer Price Index and Consumer Price Index in many countries over periods of time. Caporale et al. (2002) examine the causal relationship between wholesale and consumer prices for G7 countries. Their results indicate that WPI Granger-cause CPI. Akdi et al. (2006) investigate the relationship between the consumer price index (CPI) and the wholesale price index (PPI) using the Turkish data. Their finding shows cointegration between the series and both variables Granger-cause each other. Ghazali, Yee and Muhammed (2008), using monthly data from Malaysia between January 1986 and April 2007. They found a unidirectional causality from the PPI to the CPI. Gang et al. (2008), studying the relationship between the PPI and the CPI. They found a long-term connection between them. Their finding showed a bi-directional causality.Sidaoui et al. (2010) found there is long-term cointegration between both indexes (PPI and CPI) and causality goes from the PPI to the CPI. Shahbaz et al. (2009) investigated the relationship between PPI and CPI using monthly data for Pakistan. Their results have verified the existence of long run relationship between producer and consumer prices. They also found that there is bidirectional causality but it is stronger from producer to consumer prices.Akcay (2011) conducted a study for five selected European countries, using seasonally-adjusted monthly data between August 1995 and December 2007. He used the causality test by Toda and Yamamoto (1995). The results indicate that there is a unidirectional causality between producer price index and consumer price index, running from producer price index to consumer price index in Finland and France and bidirectional causality between two indices in Germany. In the case of the Netherlands and Sweden, no significant causality is detected. Muhammad et al. (2012) analyze the Granger causality in the frequency domain between the CPI and the WPI in Pakistan, using monthly data between 1961 and 2010. They found the causality between the CPI and the WPI varies, depending on the frequency domain. They also discovered the CPI Granger-causes the WPI in low and medium frequencies, as well as in high frequencies, which reflects long, medium and short-term cycles.The purpose of this study is to investigate causality between PPI and CPI for Iran. So, the methodology proposed by Granger (1969) and Sims (1972) is used to analyze if the PPI causes CPI. Also, we used time-series Vector Error Correction Model (VECM) approach of stationarity test, cointegration test, stability test and Granger causality test. This study uses monthly PPI and CPI data over the period March 1999 to March 2011, for Iran. We find there is a long-term cointegration between both indexes and causality goes from the PPI to the CPI. The result suggest that in Iran economy, demand-side factors have played a more important role than supply-side factors, although the two sides both have influences on domestic inflation trend which is measured by CPI.