- What is inflation?
- Inflation and Value of money
- Inflation Measurement
- Price Index
- Calculation of Price Indices
- Calculation of Inflation
- Different types of Inflation
- Is Inflation a bane or boon?
What is inflation?
Inflation is an upward movement in general prices of good and services. Inflation is a common phenomenon. But deflation, opposite of inflation is a rare phenomenon. Inflation is an important problem for the common people, as they complain of price rises; for politicians, as they have to keep prices under control and for policy makers, as they need to maintain stability and predictability of the economy.
The following diagram explains the cycle of inflation;
Inflation and value of money
The real value of money declines with inflation. For example , few months back, I used to get 1 litre petrol for 30 rupee, now I have to give 40 rupee for 1 litre. The good I got in both cases is same, but value of 40 rupees now is equal to that of 30 rupees then. ie the value of money has decreased.
Everybody feels pinch of inflation as per their income and expenditure. It is subjective. The objective measurement of inflation needs standardised method. It is generally done through comparison of price levels over the given period.
How to compare price levels in different years?
When we have to compare price levels, questions arise like, price of which goods? price of how many items? Price at which place? Etc.
It is impossible to compare the prices of all goods. Also price varies from place to place. So the concept of price indices is used.
An index number is a specialised average. ‘Specialised’ means, we can have different indices for different purposes. One particular index will take a particular group of good and services called the ‘basket’, whose price change is measured over a period of time. As per the different baskets, there are different indices.
The main indices used are Consumer Price Index(CPI), Wholesale Price Index(WPI). CPI has different types like CPI for industrial workers, CPI for Agricultural Labourers, CPI for Urban Labourers etc. The basket of commodities for each indices differ as per the context. For example WPI include fuel, power, manufactured products where as CPI include food, tobacco, housing, clothing etc
WPI vs CPI
||Calculated by monitoring the prices of certain goods that are traded at the Wholesale Market
||Calculated by collecting the Retail Cost of representative products or Services from the Categories for Urban Non-Manual Employees, Agricultural labourers, Industrial workers etc separately
|Items in the basket
||697 items including fuel, power, manufactured products etc
||Food, tobacco, housing, clothing, Bedding and Footwear etc as per the category selected
|Use in inflation calculation
||Used earlier for calculating inflation in our country
||Presently this index is used to calculate inflation
Calculation of Price Indices
Price index(PI) is calculated by measuring the rise in price of current year over the price of base year.
PI = Current year’s price/Base year’s price × 100
For example , ten years back, I used to get 1 pencil for 1 rupee, now I have to give 5 rupee for 1 pencil. If the year 10 years before is taken as base, PI = 5/1 × 100, ie 500% price rise.
The prices of items in the basket are added up. Different commodities are given different weights to account for its frequency of transaction. So price of each commodity is multiplied by its weight before adding up.
A base year is a relatively stable year (a year without much economic disruptions) selected so as to compare the price levels. The base year is periodically reviewed to keep up with the changes in economy. The selection of base year influences the price indices.
For instance in the previous example with base year 10 years before year, PI was 500. Say the price for the pencil was 2 rupees 5 years before. So if we take that year as the base, PI will be 250 (5/2X100).
Calculation of Inflation
Inflation is measured as the change in price indices over the particular period. If we take one year time as the reference period,
Inflation = (PI of current year – PI of last year)/PI of last year × 100
Let us take our example, with base year 10 years before, and price this year as 5 and price last year as rupees 4. PI of this year is 500 and PI of the last year is 400. So inflation is (500-400)/400X100 = 25%
Different Types of Inflation
It is the main inflation which catches public attention. Earlier in India, we used to calculate headline inflation using WPI, as the data was more reliable. Now we have changed to CPI based calculation, as it is the more appropriate index for headline inflation calculation.
Core inflation indicates the price changes in commodities other than the food and fuel. Food and fuel are the most volatile commodities in terms of price. So to get a better idea of actual price change, these two items are excluded to calculate the core inflation.
Is Inflation a bane or boon?
A stable and moderate inflation is essential for growth. But higher inflation affects the common people. It affects the public trust in financial systems.
Along with controlling inflation, efforts are taken to stabilise the inflation rate, so as to give better clarity in future economic transactions.
How much of an inflation is normal ?
The Monetary Policy Committee in India will decide on the favourable inflation rate, so that fiscal and monetary policies can be formulated to achieve it. the present target is 4%.