Inflation: What Is Inflation?

Inflation is defined as a sustained increase in the general level of prices for goods
and services. It is measured as an annual percentage increase. As inflation rises,
every dollar you own buys a smaller percentage of a good or service.
The value of a dollar does not stay constant when there is inflation. The value of
a dollar is observed in terms of purchasing power, which is the real, tangible
goods that money can buy. When inflation goes up, there is a decline in the
purchasing power of money. For example, if the inflation rate is 2% annually, then
theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar
can't buy the same goods it could beforehand.
There are several variations on inflation:
Deflation is when the general level of prices is falling. This is the opposite
of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to
the breakdown of a nation's monetary system. One of the most notable
examples of hyperinflation occurred in Germany in 1923, when prices rose
2,500% in one month!
Stagflation is the combination of high unemployment and economic
stagnation with inflation. This happened in industrialized countries during
the 1970s, when a bad economy was combined with OPEC raising oil
prices.

In recent years, most developed countries have attempted to sustain an inflation

rate of 2-3%.
Causes of Inflation
Economists wake up in the morning hoping for a chance to debate the causes of
inflation. There is no one cause that's universally agreed upon, but at least two

theories are generally accepted:

Demand-Pull Inflation - This theory can be summarized as "too much money
chasing too few goods". In other words, if demand is growing faster than supply,
prices will increase. This usually occurs in growing economies.
Cost-Push Inflation - When companies' costs go up, they need to increase prices
to maintain their profit margins. Increased costs can include things such as
wages, taxes, or increased costs of imports.
Costs of Inflation
Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects
different people in different ways. It also depends on whether inflation is
anticipated or unanticipated. If the inflation rate corresponds to what the majority
of people are expecting (anticipated inflation), then we can compensate and the
cost isn't high. For example, banks can vary their interest rates and workers can
negotiate contracts that include automatic wage hikes as the price level goes up.
Problems arise when there is unanticipated inflation:
Creditors lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free
loan.
Uncertainty about what will happen next makes corporations and
consumers less likely to spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
The entire economy must absorb repricing costs ("menu costs") as price
lists, labels, menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products
become less competitive.

Finally, inflation is a sign that an economy is growing. In some situations, little

inflation (or even deflation) can be just as bad as high inflation. The lack of
inflation may be an indication that the economy is weakening. As you can see, it's
not so easy to label inflation as either good or bad - it depends on the overall
economy as well as your personal situation.

Inflation: How Is It Measured?

Measuring inflation is a difficult problem for government statisticians.
To do this, a number of goods that are representative of the economy
are put together into what is referred to as a "market basket." The cost
of this basket is then compared over time. This results in a price index,
which is the cost of the market basket today as a percentage of the
cost of that identical basket in the starting year.
In North America, there are two main price indexes that measure
inflation:
Consumer Price Index (CPI) - A measure of price changes in
consumer goods and services such as gasoline, food, clothing and
automobiles. The CPI measures price change from the
perspective of the purchaser. U.S. CPI data can be found at the
Bureau of Labor Statistics.
Producer Price Indexes (PPI) - A family of indexes that measure
the average change over time in selling prices by domestic
producers of goods and services. PPIs measure price change from
the perspective of the seller. U.S. PPI data can be found at the
Bureau of Labor Statistics.

How Inflation is Measured

There are two main indices used to measure inflation. The first is the Consumer Price Index, or
the CPI . The CPI is a measure of the price of a set group of goods and services. The "bundle," as
the group is known, contains items such as food, clothing, gasoline, and even computers. The

amount of inflation is measured by the change in the cost of the bundle: if it costs 5% more to
purchase the bundle than it did one year before, there has been a 5% annual rate of inflation over
that period based on the CPI.
You will also often hear about the "Core CPI" or the "Core Rate." There are certain items in the
bundle used to measure the CPI that are extremely volatile, such as gasoline prices. By
eliminating the items that can significantly affect the cost of the bundle (in either direction) on a
month-to-month basis, the Core rate is thought to be a better indicator of real inflation, the slow,
but steady increase in the price of goods and services.
The second measure of inflation is the Producer Price Index, or the PPI . While the CPI indicates
the change in the purchasing power of a consumer, the PPI measures the change in the
purchasing power of the producers of those goods. The PPI measures how much producers of
products are getting on the wholesale level, i.e. the price at which a good is sold to other
businesses before the good is sold to a consumer. The PPI actually combines a series of smaller
indices that cross many industries and measure the prices for three types of goods: crude,
intermediate and finished. Generally, the markets are most concerned with the finished goods
because these are a strong indicator of what will happen with future CPI reports. The CPI is a
more popular measure of inflation than the PPI, but investors watch both closely .

How Inflation is Measured in India:

Inflation is usually measured based on certain indices. Broadly, there are two categories of
indices for measuring inflation i.e. Wholesale Prices and Consumer Prices. There are certain
sub-categories for these indices.

What is an Index Number :

An Index number is a single figure that shows how the whole set of related variables has changed over time or
from one place to another. In particular, a price index reflects the overall change in a set of prices paid by a
consumer or a producer, and is conventionally known as a Cost-of-Living index or Producer's Price Index as
the case may be.

Price Indexes / Indices used in India :

In India we use five major national indices for measuring inflation or price levels.

(A) The Wholesale Price Index (base 1993-94) is usually considered as the headline inflation
indicator in India.

(B) In addition to Whole Price Index ( WPI ), there are four different consumer price indices which
are used to assess the inflation for different sections of the labour force. These are discussed in
more details later on.

(C) In addition to above five indices, the GDP deflator as an indicator of inflation is available for
the economy as a whole and its different sectors, on a quarterly basis

Now let us discuss the above indices used in India to measure inflation in detail to understand
these better.

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Wholesale Price Index (WPI) :

This index is the most widely used inflation indicator in India. This is published by the Office of
Economic Adviser, Ministry of Commerce and Industry. WPI captures price movements in a most

comprehensive way. It is widely used by Government, banks, industry and business circles.
Important monetary and fiscal policy changes are linked to WPI movements. It is in use since
1939 and is being published since 1947 regularly. We are well aware that with the changing times,
the economies too undergo structural changes. Thus, there is a need for revisiting such indices
from time to time and new set of articles / commodities are required to be included based on
current economic scenarios. Thus, since 1939, the base year of WPI has been revised on number
of occasions. The current series of Wholesale Price Index has 2004-05 as the base year. Latest
revision of WPI has been done by shifting base year from 1993-94 to 2004-05 on the
recommendations of the Working Group set upwith Prof Abhijit Sen,, Member, Planning
Commission as Chairman for revision of WPI series. This new series with base year 2004-05 has
been launched on 14th September, 2010. A brief on the historical development of this WPI is
given below : -

Base Year

Year of Introduction

No of Items in
Index

No of Price
Quotations

Week ended 19th August 1939

1942

23

23

End August 1939

1947

78

215

1952-53 (1948-49 as weight

base)

1952

112

555

1961-62

July 1969

139

774

1970-71

January 1977

350

1295

1981-82

July 1989

447

2371

1993-94

April 2000

435

1918

2004-05

September 2010

676

5482

Earlier, the concept of wholesale price covered the general idea of capturing all transactions
carried out in the domestic market. The weights of the WPI did not correspond to contribution of
the goods concerned either to value - added or final use. In order to give this idea a more precise
definition, it was decided to define the universe of the wholesale price index as comprising as far
as possible all transactions at first point of bulk sale in the domestic market.

Click Here to Get More Details About:

Methodology, Basket and Weights Adopted for Revised Index Numbers

of Wholesale Prices in India with Base Year 2004-05 = 100

Click Here to View :

WPI and Inflation Data upto 2010 based on new series with base year 2004-05

Thus the latest WPI has a basket of 676 items with 5482 quotations. The major criticism for this
index is that 'the general public does not buy at the wholesale level', thus WPI does not give the actual
feeling of the amount of pressure borne by the general public. However, the increase in wholesale prices
does affect the retail prices and as such give some feel of the consumer prices.

Consumer Price Index (CPI)

The CPI measures price change from the perspective of the retail buyer. It
is the real index for the common people. It reflects the actual inflation that
is borne by the individual. CPI is designed to measure changes over time in
the level of retail prices of selected goods and services on which consumers
of a defined group spend their incomes. Till January 2012, in India there
were only following four CPIs compiled and released on national level. (In

some countries like UK, Malaysia, Poland it is also known as Retail Price
Index).

(1) Industrial Workers (IW) (base 2001),

(2) Agricultural Labourer (AL) (base 1986-87) and
(3) Rural Labourer (RL) (base 1986-87)
(4) Urban Non-Manual Employees (UNME) (base 1984-85),

The first three are compiled by the Labour Bureau in the Ministry of Labour and Employment, and the
fourth is compiled by Central Statistical Organisation (CSO) in the Ministry of Statistics and Programme
Implementation. These four CPIs reflect the effect of price fluctuations of various goods and services
consumed by specific segments of population in the country. These indices did not encompass all the
segments of the population and thus, did not reflect the true picture of the price behaviour in the country as a
whole.

Some of the Data for 2012 for above indices :

WPI (All
commoditi
es)

Base
Period

WPI Inflation
Rate

2001=
100

CPI - AL CPI - RL
CPI Point to CPI - Rural - Point
(IW)
Point Labourers to Point

1986
Point
87=1
Inflation
00 Inflation

198687=100

Inflatio
n

Period
Jan-12

158.70

7.23 198.00

618.
5.32
00

Feb-12

159.30

7.56 199.00

7.57 621.

4.92

619.00

5.27

6.34

623.00

6.68

00
625.
8.65
00

6.84

626.00

7.19

Mar-12

161.00

7.69 201.00

Apr-12

163.50

7.50 205.00

10.22

633.
00

7.84

634.00

8.01

7.55 206.00

638.
10.16
00

7.77

640.00

8.11

7.25 208.00

646.
10.05
00

8.03

648.00

8.54

6.87 212.00

656.
9.84
00

8.61

658.00

8.94

May-12
Jun-12
Jul-12

163.90
164.20
164.80

New Series of CPI Started in 2012

Therefore, there was a strong feeling that there is a need for compiling CPI for entire urban and rural
population of the country to measure the inflation in Indian economy based on CPI. Thus, now Central
Statistics Office (CSO) of the Ministry of Statistics and Programme Implementation has started compiling a
new series of CPI for the

(a) CPI for the entire urban population viz CPI (Urban);
(b) CPI for the entire rural population viz CPI (Rural)
(c) Consolidated CPI for Urban + Rural will also be compiled based on above two CPIs

These would reflect the changes in the price level of various goods and services consumed bythe Urban and
rural population. These new indices are now compiled at State / UT and all India levels.

The CPI inflation series is wider in scope than the one based on the wholesale price index (WPI), as it has
both rural and urban figures, besides state-wise data. The new series, with 2010 as the base year, also includes

services, which is not the case with the WPI series. However, this new series will become comparable only in
2013 when the data for 2012 will also be available for comparison.

A comparison of this new series with WPI is given below :-

WPI

CPI - New Series

wef Feb 2012

Base Year

2004-05

2010

Elemenetary Items

676

200 (Weighted
items)

Weightage o Food
products (%)

243

49.71

Weightage of Energy
products (%)

14..91

9.49

Service
Weightage of
s not
Miscellaneous Items (%) include
d

26.31

Some of the Data Released under this New Series :

Period

Rural - CPI /
Urban - CPI /
Combined - CPI / Annual
Annual Inflation Annual Inflation Inflation (Prov.)
- Prov
Prov.

May 2012

119.1

117.1

118.2

June 2012

117.5

118.5

119.6

July 2012

122.6

119.9

121.4

9.76%

10.0%

9.86%

Producer Price Indexes (PPI)

These are indices that measure the average change over time in selling
prices by producers of goods and services. They measure price change from
the point of view of the seller. Majority of OECD countries measure inflation
based on Producer Price Indiex (PPI) while only some others use WPI.
Countries like Japan, Greece, Norway and Turkey use WPI. Already WPI has
been replaced in most of the countries by PPI due to the broader coverage
provided by the PPI in terms of products and industries and the conceptual
concordance between PPI and system the national account. PPI is
considered to be more relevant and technically superior compared to one at
wholesale level. However, in India we are still continuing with WPI.

Cost-of-living indices (COLI):

This is different from CPI. This index aims to measure the effects of price
changes on the cost of achieving a constant standard of living (i.e. level of
utility or welfare) as distinct from maintaining the urchasing power to buy a
fixed consumption basket of good and services. Maintaining a constant
standard of living does not imply continuing to consume a fixed basket of
goods and services. A COLI allows for the fact that households who seek to
maximize their welfare from a given expenditure can benefit by adjusting
their expenditure patterns to take account of changing relative prices by
substituting goods that have become relatively cheaper, for goods that
have become relatively dearer. The use or preference for a particular
goods may also change.

In the long run, the various PPIs, WPIs and the CPI show a similar rate of inflation. In the short run PPIs
often increase before the WPI and CPI. Investors generally follow the CPI more than the PPIs. In India WPI
is used instead of CPI.

In News Recently :

What is Core Inflation : The concept is used to estimate the inflation by excluding food and energy
prices from the basket of goods and services that represents a typical household's consumption. In mid 2012,
RBI Governor threw up the conundrum posed by this "Core"inflation by saying "In our economy, where
food constitutes nearly 50% of consumption basket and fuel has a weight of 15%, can a measure of inflation
that excludes them can be called "Core". He suggested that India should move towards developing and
using a Producer Price Index (PPI) to gauge inflation more accurately as wholesale price index does not
capture the price movement of services and is a hybrid of consumer and lproducer lprice quotes.