Price indices as measures of inflation: a conceptual study

Amit SinhaAnjali ChinchanikarRatan KumarTarun Saha

Inflation

Inflation is a state of persistent rise in prices

Note: This does not mean that all prices must be rising during

a period of inflation –some prices may even be falling; but the general trend must be upward

It is a process of rising prices & not a state of high prices

Inflation contd..

The Demand-Pull inflation → originates from demand side of the economyIf aggregate monetary demand for domestic output exceeds the value of the full employment output at current prices, then the price level will rise.

The Cost-Push inflation → originates from supply side of the economyIt is caused by rising cost of production independently of the excess demand in the market.

Measuring Inflation

Inflation is the rate of change in the price level

If the price level in the current year is ‘P1’ & in the previous year is ‘Po’, then inflation for the current year is

(P1 – Po)/ Po x 100

Inflation trends in India

Price Index as a measure of Inflation(1/3) What is price index?

A price Index is a normalized average level (typically a weighted average) of prices

Types of price indices Laspeyres index Paasche Index

Price Index as a measure of Inflation(2/3) Laspeyres index

measures the change in cost of purchasing the same basket of goods and services in the current period as was purchased in a specified base period

Price Index as a measure of Inflation(3/3) Paasche Index

compares the cost of purchasing the current basket of goods and services with the cost of purchasing the same basket in an earlier period

Measuring Inflation using CPI

Consumer Price Index (CPI) measure of the average price of consumer goods and services

purchased by households used to index (i.e., adjust for the effects of inflation) wages,

salaries, pensions, or regulated or contracted prices Calculating the CPI

elementary indices are created to show the price levels of very similar goods in the same area

the elementary indices are combined to create a number of aggregate indices, including the CPI using a Laspeyres index

CPI calculation contd..

CPI in period t = CPI in period(t-1) * weighted change in price in price in period t, where

weighted change in price in period t = Sum (relative importance of good i in (t-1)) * [percentage increase of good i from (t-1) to t ]

Calculating inflation rate using CPI

Formula for Inflation rate : ((B-A)/A)*100

Illustration If exactly one year ago the Consumer Price Index was

178 and today the CPI is 185, then the calculations would look like this:

 ((185-178)/178)*100 or

(7/178)*100 or

  0.0393*100 

which equals 3.93% inflation over the sample year.

Measuring Inflation using WPI(1/2)

Wholesale Price Index measures average changes in prices received by domestic producers for their output

A total of 435 commodity prices make up the index.

Official measure of inflation and its effect on the consumption pattern of the common man in India

Measuring Inflation using WPI(2/2) 435 items in WPI are divided into 3 main categories

Primary articles fuel, power, light and lubricants manufactured products

Category No of items Items included Weightage (%)

Primary articles 98 Food items and non food items like jute

22.02

Fuel, power, light and lubricants

19 coal and petroleum related products, lubricants, electricity etc.

14.23

Manufactured Products

318 dairy products, atta, biscuits, edible oils, liquors, cloth, toothpaste, batteries, automobiles etc

63.45

Calculating WPI(1/2)

The price data are scrutinized; price relative for each price quote is calculated. Price relative is calculated as the ratio of the current price to the base price multiplied by 100 i.e. (P1/Po)X100

Commodity/item level index is arrived at as the simple arithmetic average of the price relatives of all the varieties (each quote) included under that commodity

The indices for the sub groups/groups/ major groups are compiled and the aggregation method is based on Laspeyres formula as below

I= S (Ii x Wi) / S Wi Where, I = Index numbers of wholesale prices of a sub- group/group/ major group/ all commoditiesS = represents the summation operation,Ii  = Index of the ith item / sub- group/ group/ major group.Wi = Weight assigned to the ith item of sub- group/group/ major group.

Calculating WPI(2/2)

WPI is calculated on a base year and WPI for the base year is assumed to be 100. To show the calculation, let’s assume the base year to be 1970. The data of wholesale prices of all the 435 commodities in the base year and the time for which WPI is to be calculated is gathered.

Let's calculate WPI for the year 1980 for a particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1970 = Rs 5.75 and in 1980 = Rs 6.10

The WPI of wheat for the year 1980 is,(Price of Wheat in 1980 – Price of Wheat in 1970)/ Price of Wheat in 1970 x 100

i.e. (6.10 – 5.75)/5.75 x 100 = 6.09

Since WPI for the base year is assumed as 100, WPI for 1980 will become 100 + 6.09 = 106.09.

In this way individual WPI values for the remaining 434 commodities are calculated and then the weighted average of individual WPI figures are found out to arrive at the overall Wholesale Price Index. Commodities are given weight-age depending upon its influence in the economy

Inflation calculation based on WPI

Inflation = (WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100

For example, WPI on Jan 1st 1980 is 106.09 and WPI of Jan 1st 1981 is 109.72 then inflation rate for the year 1981 is,

(109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year 1981 is 3.42%.

Inflation rate for 2008

CPI Vs WPI CPI WPI

Weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care

Primary articles fuel, power, light and

lubricants manufactured products

Average price of consumer goods and services purchased by households

Average changes in prices received by domestic producers for their output

Indicative of the actual consumer price at retail level

Indicative of the wholesale prices

Food gets maximum weightage of 57% Food articles in the primary group and food products in the manufactured products group together have a weight of only 27%

Includes services in measurement like health, education

WPI ignores services for which the consumer pays a lot out of his monthly budget.

Outcome-Should India shift to CPI

Yes and No Yes because

CPI is a measure of direct impact to consumers Includes health, education and other services that is directly

consumed by masses No because

Indian consumer is diverse (rural,urban) so a generalization is practically impossible.

Monthly analysis as compared to WPI which is weekly analysis and thus is more recent.

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