Inflation basics

• What is Inflation?
• Measures of Inflation.
• Economic Effects of Inflation
 What is Inflation

• A persistent and appreciable rise in price level.

• Difficult to define precisely.
 Measures of inflation

• CPI
• WPI
• GDP deflator
 Effects of inflation

• Depends on how far the groups affected can anticipate inflation.

• Those who correctly anticipate inflation and are able to protect
themselves from the loss of income and wealth that wd otherwise
occur are able to protect themselves from the hurt in the process.
• If people are able to increase their income and market value of
wealth as fast as the prices rise, is not hurt by inflation.
• But this has to result automatically from inflation-e.g a money
wage rate increase that results from a COL adjustment and not for
any other reason.
• If the person has worked greater no. of hrs to offset this inflation,
his real income and wealth may be unchanged. However, this has
been achieved by a sacrifice of leisure – a loss.
Effects of inflation on distribution of income and wealth

• Infln affects mostly those with higher incomes when incomes

are measured to include the changes in net worth caused by
infln.
 General Price level
• 3 diff measures of price level.

Consumer Price Index(CPI)

Wholesale Price Index(WPI)

GDP Deflator
• Each is a wted average of several prices and is
presented as an index no.
• CPI signals changes in prices facing the consumer.
• WPI the changes in price facing the producer.
• GDP Deflator signals the overall national price
changes.
• Each in its own way provides a measure of inflation in
the economy.
• None is a perfect measure.
 CPI
• The CPI is a measure of the overall cost of gds and
svs bought by a typical consumer.
• It is used to monitor the changes in the cost of living
over time.
• When the CPI rises, typically the family has to spend
more money to maintain the same living standards.
 CALCULATION OF CPI
Fix the basket

Find the price

Compute the basket cost

Choose a base year

Compute the Index

Compute the inflation rate

• We need the consumption basket in the base year and
• Price relatives for each item in the given yr--------------
to calculate the weights W₁….Wn.
• This can be used to calculate the index.
• In practice, cannot take all the consn items. Hence take
groups of items- food, tobacco, fuel and light, housing
etc. with further sub-groupings e.g within food-
pulses, cereals etc. Even here, not necessary to
include all items in the calculation; if prices of groups
of items show closely similar movements, only one of
them needs to be included in the index calculation.
• E.g in the vegs and fruits gp, only a couple of vegs and a couple of
fruits can be selected for monitoring price movements; prices of others
wd presumably move more or less in unison with the selected items.
• The consumption basket data comes from family budget surveys
carried out from time to time. These surveys yield estimates of
commodity composition of consumption expenditures of a typical
family in a specified population gp.These surveys are conducted by the
CSO and are done every 5 yrs.
• Price data is obtained from the retail outlets by a large staff of field
investigators.
• The base yr is changed from year to year so that account can be taken
of the changes in tastes, appearance of new items in the consn basket.
• Without such updating, the index wd lose its usefulness as an
approximate measure of the COL.
 CONSTRUCTION OF CPI
Item Qty 2000-01- Prices 2000-01- Prices 2009-10 Price relative
base year base year Current year 2009-10=Prices
2009-10/Prices
(1) (2) (3) 2000-01*100
(0) (4)
RICE 15 Kg Rs.3/kg Rs. 4/kg 133
WHEAT 10kg Rs.2/kg Rs.3/kg 150
MILK 30 ltrs Rs.3/ltr Rs.5/ltr 167

COTTON CLOTH 5 mtrs Rs.8/mtr Rs.12/mtr 150

HOUSING A 2-room Rs.100/p.m Rs.200 p.m 200

house
 CONSTRUCTION OF CPI
Item Wi= base year Price relative Wi* Price Laspeyre’s CPI=
weights=poqo/ 2009-10=Prices relative (4*5) ∑wi
∑pioqio 2009-10/Prices Piᵗ/Pio*100=
(5) 2000-01*100 (6) ∑6
(7)
R(ICE 45/295=0.15 133 19.95
WHEAT 20/295=0.07 150 10.5
MILK 90/295= 0.30 167 50.1

COTTON CLOTH 40/295= 0.14 150 21

HOUSING 100/295= 0.34 200 68 169.55

• EXP.in 2000-01=piₒ qiₒ=Rs.295
• WEIGHTS
• Share of milk in total exp in 2000-01= 90/295= 0.30
• Wmilk=exp on milk in base pd/ total exp in base
pd=pₒmilk qₒmilk/ piₒ qiₒ= 90/295=0.3
• Similarly,W rice=0.15, Wwheat=0.07, cloth=0.14,
housing=0.34, The weights sum to unity.
• Assume the base year weights hold in the current year
also. This is a crucial assumption in the construction of
the CPI.
• What it means is that the consn basket and the
proportionate share of each item in the basket does
not change from the base year to the current year.
• Then calculate the Price relatives.PR= Current year P/ Base
year P*100.
• This tells us the increase in the P of each item in the consn
basket between the base year and the current year.
• Price Relative cloth= p1 cloth/po cloth*100=12/8*100= 150.
• Thus, between 2000-01 and 2009-10, price of cloth has risen
by 50%.
• We need a composite index to know what is the increase in
the cost of the basket in 2009-10 compared to 2000-01. For
this, we multiply the weights by the price relatives and sum
up to obtain a weighted average for the entire basket.
• Laspeyre’s CPI=Iᵗ= ∑wi Piᵗ/Pio*100=169.55
• This means that between the base year and the current year,
the cost of the entire basket has gone up by 69.55%.
• Points regarding CPI:
• CPI covers all gds and svs entering the consn
basket(including imported goods). However food and
fuel prices may be left out due to their volatility.
• The relevant price is the retail Price.
• Quantity weights are constant and are the base year
weights (col5) .
• In India, CPI is reported with a 2month time lag.
• It is constructed for CPI AL, CPI Urban Industrial
workers, CPI urban non-manual employees.
 WPI
• Methodology same as CPI construction.
• Only the data changes.
• Column 0 consists of a much larger basket of goods.
• The wholesale price index consists of over 2,400
commodities. The indicator tracks the price
movement of each commodity individually.
• Unlike the CPI, it considers only goods and excludes
all services.
• In column 1, it considers the transactions of each
item in the wholesale mkt.
 WPI
• In column 2 and 3, it takes into consideration
wholesale and not retail prices.
• In column 5, weights are based on the value of
transactions in the various items in the base year.
Like in CPI, the base year weights are fixed.
• Then, calculation of price relatives and Laspeyre’s
index is the same as the CPI.
 Points regarding WPI
• It includes only goods(including intermediate goods) and
no svs.
• It can be interpreted as an index of prices paid by
producers for their inputs.
• Relevant price is the wholesale price.
• Quantity weights are constant.
• Articles covered- The basket consists of Primary articles,
Manufactured articles, Fuel Power, light and lubricants.
• In India, it is reported with a 2 week lag.
• In India, movements in WPI are used to measure the
inflation and CPI, the cost of living changes in the
economy.
 GDP DEFLATOR
• Revision of gdp concepts:
• Nominal GdP= Value of final gds and svs in current
prices.
• Real GDP= Value of final gds and svs in constant
prices.
• GDP Deflator= Nominal GDP/ Real GDP*100
• A manager’s interest is in real GDP. It allows direct
comparison of physical output from one year to the
next, since a constant measuring device has been
used.
Good or Base P Base Q Current P Current Q
service(item)
X1 2 40 3 60
X2 8 90 10 150
X3 80 100 90 110
X4 70 120 80 130
• Base pd GDP=17200
• Nominal GDP= Current q*current P= 21980
• Real GDP= Current Q* base price= 19220.
• Growth in nominal GDP= 21980-
17200/17200*100=27.79%.
• This is partly due to an increase in Q and partly due
to increase in P.
• Growth in real GDP= 19220-
17200/17200*100=11.74%.
• This reflects increase in Q alone.
• By holding price constant at the base level, we have
eliminated the impact of any change in P during this
pd in the estimation of real GDP growth.
• What was the increase in P during this pd that we
eliminated?
• The GDP deflator gives this and is obtained by-
• Nominal GDP/ Real GDP*100.
• Here GDP deflator= 21980/19220*100=114.36.
• Hence the increase in prices during this pd, which we
eliminated in the real GDP growth calculation was
14.36%
• Symbolically, GDP deflator= ∑ptqt/ ∑poqt.
• Hence, unlike CPI and WPI, qty weights are not fixed. They
vary each yr.
• We come to know of the qty produced of gds and svs of each yr
only at the end of the yr. hence GDP deflator comes with a one
year time lag.
• It is the most comprehensive measure of changes in the general
price level as it considers all domestically produced final gds
and svs.
• Prices considered are retail prices.
• Calculate GDP deflator by dividing GDP mp (current) by
GDPmp(base) *100 for the last 10 yrs.
• Also look at CPI-AL, CPI-IW, CPI-UNM and WPI for last 10
yrs. WPI is a single series expressed as an annual average.
• CPI time lag is 2 months.
• With rapid change in consn habits, using a fixed qty
weight for an extended pd of ime is questionable.
• WPI suffers from a serious flaw. It does not consider svs.
• With svs accounting for more than 50% of India’s GDP,
this is a serious omission.
• Also inclusion of intermediate gds leads to a cascading
effect on prices.
• WPI however is available with the least time lag of 2
weeks.
• GDP deflator is the broadest indicator of changes in the
dom price level. But comes with a longer time lag. Also
the data is subject to frequent revisions with revision in
GDP figures.
WPI
WPI
WPI